A financial institution wants to structure an Istisna'a contract for the development of a large-scale AI software platform. The current wording of FAS 10 on 'well-defined subject matter' and 'determination of cost' is causing uncertainty for intangible assets like software development.
- Here are the key areas needing enhancement from the analysis, presented as a list:
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- Providing specific guidance on defining the subject matter ("Al-Masnoo'") for intangible assets and services, adapting criteria like "Kind, Type, Quality, and Quantity".
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- Clarifying the definition of "Istisna'a costs" in the context of intangible asset creation, addressing how to classify activities that resemble traditional R&D but are integral to the contracted "production" of software or AI.
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- Offering specific considerations or modified criteria for applying the Percentage-of-Completion method to projects with high inherent estimation uncertainty, such as complex software development.
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- Building explicitly on the allowance for services/intangibles as subject matter (Footnote 7) within the main body of the standard, dedicating sections to their specific considerations and accounting implications.
Analysis:
The proposed enhancements to AAOIFI FAS 10 aim to adapt the standard for Istisna'a and Parallel Istisna'a contracts to better accommodate intangible assets and services. From a Shariah perspective, the core principles governing Istisna'a require clarity regarding the subject matter (Al-Masnoo'), the price, and the delivery terms to avoid excessive uncertainty (Gharar).
Proposal 1 directly addresses the definition of Al-Masnoo' for intangibles. The original standard's criteria (Kind, Type, Quality, Quantity) are inherently geared towards tangible goods. The proposal provides relevant interpretations and examples for intangible outputs like software or services. Crucially, it maintains the fundamental Shariah requirement to remove Gharar by ensuring the subject matter is known and specified. The allowance for phased specifications in complex projects, provided the overall scope and key deliverables are sufficiently clear at inception, is a pragmatic approach that aligns with the reality of modern development cycles while still adhering to the Shariah principle of mitigating Gharar regarding the final outcome. This adaptation is necessary and consistent with the underlying Shariah permissibility of Istisna'a for specified outputs.
Proposals 2 and 3 deal primarily with the accounting treatment of costs and profit/loss recognition. Shariah principles require fair and transparent financial reporting, but they do not mandate specific accounting methodologies like the capitalization of development costs or the use of the Percentage-of-Completion method. Proposal 2 clarifies that development costs directly attributable to the contracted intangible asset can be included in Istisna'a costs. This aligns the accounting definition with the economic reality of producing such assets, where development is the core "manufacturing" activity. This does not violate any Shariah principle related to the contract itself; it is an accounting classification. Similarly, Proposal 3 provides flexibility in applying the Percentage-of-Completion method to complex intangible projects, allowing its use if reliable methods for measuring progress and estimating costs exist. This is an accounting judgment regarding revenue/profit timing and does not impact the Shariah validity of the underlying Istisna'a contract, provided the basis for the method is sound and disclosed. The retrieved excerpts (Documents 1, 2, 3) primarily discuss accounting procedures related to costs, losses, and billings within the existing Istisna'a framework, reinforcing that these proposals are extensions of accounting treatments rather than fundamental Shariah contract alterations.
Proposal 4 seeks to integrate the explicit mention of intangible assets and services into the main body of the standard's scope. This is a structural enhancement that aligns the standard's presentation with accepted contemporary Shariah rulings that permit Istisna'a for services and intangible outcomes, as already acknowledged in the current standard's footnote 7. This move enhances clarity and emphasizes the broader applicability of the standard.
Overall, the proposals are consistent with the fundamental Shariah principles of Istisna'a and seek to provide practical guidance for their application in the context of modern assets and services, primarily addressing accounting treatment adaptations without altering the core Shariah requirements of the contract.
Concerns:
- While Proposal 1 clarifies how to define intangible subject matter and allows for phased specifications, the assessment of whether the "overall scope and key deliverables are sufficiently clear at contract inception to mitigate significant Gharar" for complex, novel intangible assets (like advanced AI) can still be highly subjective. This inherent difficulty in precisely defining the outcome of cutting-edge development could potentially lead to disputes or uncertainty that, from a strict Shariah perspective, might still border on Gharar if not managed carefully through robust contract wording and clear milestones.
- None.
Recommendations:
- In Proposal 1's guidance on phased specifications, add an explicit emphasis that the initial clarity required at contract inception must include a clear definition of the functional outcome or performance criteria expected from the intangible asset or service, not just a high-level description, to ensure sufficient Gharar mitigation regarding the final deliverable.
- None.
Analysis:
The proposed enhancements to AAOIFI FAS 10 are timely and necessary to address the increasing use of Istisna'a contracts for the creation of intangible assets and services within Islamic financial institutions. The current standard, while fundamentally sound, is predominantly framed around tangible manufactured goods, leading to ambiguities when applied to software development, digital content creation, or complex service outcomes.
Proposal 1: Guidance for Defining Intangible Subject Matter (Al-Masnoo') This proposal directly addresses a fundamental aspect of the Istisna'a contract from both a Shari'a and accounting perspective: the clear definition of the subject matter (Al-Masnoo'). The adaptation of the existing criteria (Kind, Type, Quality, Quantity) to intangible assets and services is logical and essential for ensuring contract validity (removal of Gharar). From an accounting standpoint, a clear definition of Al-Masnoo' is crucial for several reasons:
- Recognition: It confirms the existence of a specific asset/service being produced, allowing for the recognition of costs incurred towards its creation as Istisna'a work-in-progress.
- Measurement of Progress: Defining the scope, specifications, and quantity (or scale) of the intangible asset/service provides the necessary basis for measuring the percentage of completion, a key input for applying the percentage-of-completion method.
- Valuation: A clear definition is needed for assessing the recoverable amount of the work-in-progress, particularly in case of anticipated losses, as illustrated in Appendix A, Example 3 (Document 1). The acknowledgment that specifications may be defined in phases for complex projects is practical, provided the initial scope is sufficiently clear to mitigate Gharar. This aligns accounting recognition with project milestones typical in software development, for instance.
Proposal 2: Clarification of Istisna'a Costs for Intangible Assets This is perhaps the most impactful proposal from a financial accounting perspective. The current blanket exclusion of "research and development costs" (para 2/1(a)) is problematic when the contracted activity is essentially development. Intangible asset creation, like software development, often involves significant development effort. Capitalizing development costs directly attributable to the contracted Al-Masnoo' aligns the accounting treatment more closely with the economic reality of the Istisna'a contract – where the institution is paying for the creation of a specific, unique asset/service. In the context of FAS 10, Istisna'a costs are capitalized as 'Istisna'a work-in-progress' (as seen in Document 1, Appendix A and Document 2, para 2/2(a)). Including directly attributable development costs in this pool is consistent with the concept of accumulating all costs necessary to bring the contracted asset to its intended state for delivery. This proposal differentiates between general research (which seeks new knowledge and is typically expensed) and specific development (which applies findings to create a specific item and can be capitalized if criteria are met, as per general accounting principles for internally generated intangibles, although FAS 10 governs the contract). The proposed wording "essential to the production process defined in the contract" provides a link back to the contractual specifications (Proposal 1), which is a sound basis for determining direct attribution.
Proposal 3: Application of Percentage-of-Completion Method for High Uncertainty Projects This proposal addresses the profit recognition method for complex intangible projects. The standard currently mandates the Completed-Contract Method (CCM) if costs cannot be estimated with "reasonable accuracy" (Appendix E). While CCM is prudent in cases of high uncertainty, it defers profit recognition until completion, potentially distorting the reporting of performance over the project's life. The Percentage-of-Completion Method (PoC) generally provides a more faithful representation of the entity's performance during the reporting period. This proposal seeks to allow the use of PoC for complex intangibles if reliable methods for measuring progress and estimating costs can be established. This shifts the focus from the inherent nature of the asset (intangible = uncertain) to the reliability of the estimation and measurement processes employed by the institution. Suggesting criteria like verifiable milestones or completed modules provides practical examples relevant to intangible development. Requiring disclosure of the basis for assessing reasonable accuracy and measuring progress enhances transparency, which is crucial when estimates are inherently challenging. This approach encourages institutions to implement robust project management and accounting systems capable of supporting reliable estimation and progress tracking for intangibles, thereby potentially enabling the use of PoC.
Proposal 4: Integration of Intangible/Service Subject Matter into Main Standard Body This is a structural enhancement that improves the clarity and prominence of the standard's applicability. Moving the explicit mention of intangibles/services from a footnote in the juristic rules to the main scope section ensures that users of the standard are aware of its broader applicability from the outset. This sets the context for the specific accounting considerations detailed in the other proposals and reinforces that the principles of FAS 10 apply regardless of whether the Al-Masnoo' is tangible or intangible. This enhances the usability and accessibility of the standard for institutions undertaking such contracts.
Overall, the proposals represent a logical evolution of FAS 10, adapting its core principles to the realities of modern manufacturing and service creation, particularly in the digital realm, while maintaining consistency with Shari'a requirements and improving accounting clarity and relevance.
Concerns:
- Subjectivity in Capitalizing Development Costs (Proposal 2): While the intention to capitalize directly attributable development costs is appropriate, the practical application of distinguishing capitalizable "development" costs from non-capitalizable "research" or general overheads, especially in complex intangible projects (like novel AI development), can be highly subjective. The criteria "directly attributable" and "essential to the production process defined in the contract" require clear interpretation and consistent application across institutions to avoid variations in reported profit and asset values. This subjectivity could potentially lead to aggressive capitalization practices if not accompanied by robust guidance and examples.
- Assessing "Reliable Methods" for PoC (Proposal 3): The proposal allows PoC if "reliable methods" for measuring progress and estimating costs can be established for complex intangibles. The assessment of what constitutes a "reliable method" can also be subjective. Without further guidance or examples specific to different types of intangible development (e.g., software, digital content, bespoke service platforms), institutions might adopt methods that appear reliable on the surface but do not truly mitigate the inherent estimation uncertainty, potentially leading to premature or overstated profit recognition.
Recommendations:
- Provide more detailed implementation guidance or illustrative examples within FAS 10 (perhaps in an appendix, similar to Appendix A) to clarify the application of Proposal 2. This guidance should help institutions differentiate between capitalizable development costs and non-capitalizable research/general costs in the context of intangible asset creation under Istisna'a contracts, potentially linking specific types of activities (e.g., coding, specific design work) to the contractual specifications versus more general R&D activities.
- Enhance the disclosure requirements related to Proposal 3. In addition to disclosing the basis for determining reasonable accuracy and measuring progress, require institutions to disclose the specific methods used for cost estimation and progress measurement for significant Istisna'a contracts involving complex intangibles. This increased transparency would allow users of financial statements to better understand the estimates and judgments made in applying the percentage-of-completion method in these challenging scenarios.
Analysis:
The proposed enhancements address critical areas for adapting AAOIFI FAS 10, which is primarily framed for tangible manufactured goods, to the context of intangible assets and services. This is a necessary evolution given the increasing application of Istisna'a contracts in digital and service-based industries.
Proposal 4, which suggests integrating the applicability to intangible assets and services into the main body of the standard (Section 1. Scope), provides a logical starting point. Elevating this from a footnote to a dedicated section clarifies the standard's intended scope upfront and sets the stage for subsequent specific guidance related to intangibles. This improves the overall structure and clarity of the standard for users dealing with such contracts.
Proposal 1 directly tackles the challenge of applying the fundamental Shari'a requirement of specifying the subject matter (Al-Masnoo') to intangible assets. The proposed adaptation of the "Kind, Type, Quality, and Quantity" criteria provides relevant examples for intangibles, making the standard more practical and understandable for contracts involving software, services, etc. The acknowledgment that specifications may be defined in phases for complex intangibles, while emphasizing initial clarity to mitigate Gharar, appears consistent with both practical project management and Shari'a requirements, provided the 'overall scope and key deliverables' are indeed sufficiently clear.
Proposal 2 addresses a significant accounting challenge: the treatment of development costs for intangible Istisna'a assets. The current blanket exclusion of "research and development costs" is problematic because the creation of software or AI under an Istisna'a contract is fundamentally a development process. Differentiating between general research and directly attributable development costs aligns the accounting treatment with the economic substance of incurring costs to fulfill the contract. Including essential, directly attributable development costs in Istisna'a costs provides a more accurate measure of the cost of the asset being produced under the contract, consistent with the principle of capitalizing costs necessary to bring an asset to its intended condition.
Proposal 3 focuses on the application of the Percentage-of-Completion (POC) method to complex intangible projects. The original standard correctly highlights the need for "reasonable accuracy" in cost estimation for using POC. The proposal acknowledges the inherent uncertainty in intangible development but suggests that POC may still be appropriate if reliable measurement and estimation methods can be established. This provides necessary flexibility and encourages the use of POC (generally preferred for providing timely financial information) where robust project management and accounting systems are in place, rather than forcing the less informative Completed-Contract method solely due to the nature of the asset. The requirement for disclosure of the basis for determining reasonable accuracy and measuring progress enhances transparency.
Overall, the proposals appear consistent with the underlying principles of Istisna'a contracts and the general objectives of financial reporting (relevance, reliability). They aim to adapt existing principles to new contexts rather than introducing fundamentally new concepts, enhancing the standard's applicability and relevance in the modern economic landscape. The retrieved excerpts regarding loss recognition and WIP measurement reinforce the context of cost accumulation and valuation, areas directly impacted by the proposed clarifications on costs and measurement methods.
Concerns:
- Clarity and Verifiability of Intangible Specifications: While Proposal 1 provides examples for Kind, Type, Quality, and Quantity for intangibles, terms like "nature of the output," "specific class," "performance metrics," "functional specifications," and "scope of features" can be subjective or difficult to define with the same precision as tangible goods. The phrase "sufficiently clear... to mitigate significant Gharar" in the context of phased specifications for complex intangibles requires careful interpretation and could be a source of ambiguity in practice.
- Defining "Directly Attributable Development Costs": Proposal 2 differentiates between research and development costs, allowing capitalization of development costs "directly attributable to the creation of the specific contracted Al-Masnoo'". While necessary, distinguishing between general development efforts (excluded) and project-specific development (included) can be challenging in practice, especially in agile or iterative development environments. Clearer guidance or examples might be needed to prevent inconsistent application.
Recommendations:
- For Proposal 1, add guidance or examples on what constitutes "sufficiently clear" specifications at contract inception for complex intangibles with phased definitions, perhaps referencing common industry practices for software/service contracts that ensure key parameters are locked down early. Consider adding a requirement for specific contractual clauses outlining the phased definition process and milestones.
- For Proposal 2, include illustrative examples or further criteria to help distinguish between general development costs (excluded) and development costs directly attributable to the specific contracted intangible asset (included), potentially referencing project-specific activities vs. platform-level or reusable component development.
Analysis:
The proposed enhancements to AAOIFI FAS 10 are aimed at adapting the standard for Istisna'a and Parallel Istisna'a contracts to the context of intangible assets and services, such as software development or bespoke service creation. From a Shariah perspective, Istisna'a is a contract permitted by Istihsan (juristic preference based on need and common practice) despite deviating from the strict Qiyas requirement of the subject matter being in existence at the time of contract (Document 1). This foundation of Istihsan and Maslaha (public interest) supports the principle of adapting the contract's application to meet contemporary needs, provided the core Shariah requirements are met.
Proposal 4, which suggests incorporating specific considerations for intangible assets and services into the main body of the standard, is a logical and beneficial structural change. It explicitly acknowledges and builds upon the existing Shariah allowance mentioned in Footnote (7) (Document 1) that the subject matter (Al-Masnoo') "may be a commodity, service or both." This enhanced clarity in the standard's scope is consistent with the Shariah principle of removing ambiguity where possible.
Proposal 1 directly addresses the crucial Shariah requirement of specifying Al-Masnoo' to remove Gharar. The original criteria (Kind, Type, Quality, Quantity) are clearly designed for tangible goods. The proposed modifications provide necessary examples and guidance on how to apply these criteria to intangibles and services. The addition of sub-point 4/1/1(e) emphasizing detailed functional specifications, performance standards, and technical requirements is essential for mitigating Gharar in intangible contracts. The acknowledgment that detailed specifications for complex intangibles may develop iteratively, provided the overall framework and core requirements are sufficiently defined initially, is a pragmatic approach aligned with modern development methodologies. This flexibility is acceptable from a Shariah standpoint only if the initial definition is robust enough to prevent material uncertainty about the essential nature and expected outcome of the deliverable at the time of contract formation. The previous Shariah expert's concern regarding the subjectivity of "sufficiently clear" is pertinent here.
Proposal 2 deals with the classification of Istisna'a costs, specifically the treatment of research and development (R&D) activities. The proposed modification clarifies that R&D activities integral to the contracted process of creating the specific intangible Al-Masnoo' can be included in Istisna'a costs. This is primarily an accounting treatment and does not, in itself, violate any core Shariah principle related to the Istisna'a contract. The contract's Shariah validity rests on the agreement on the specified Al-Masnoo' and price, not on how the manufacturer accounts for their internal costs. Including directly attributable development costs aligns the accounting with the economic reality of producing the intangible asset under contract.
Proposal 3 focuses on the Percentage-of-Completion (PoC) method for revenue recognition in projects with high estimation uncertainty, typical of complex intangibles. Like Proposal 2, this is primarily an accounting methodology for timing profit recognition. Shariah generally requires that profit be realized from a valid transaction, but it does not mandate specific accounting methods for recognizing that profit over time for long-term contracts. The permissibility of PoC is contingent on the ability to estimate costs and measure progress with "reasonable accuracy." The proposal acknowledges the higher uncertainty for intangibles and provides considerations for assessing "reasonable accuracy" in this context. This is an accounting judgment based on operational reliability. From a Shariah perspective, the concern would be if the method leads to reporting profits that are entirely speculative or based on unreliable estimations, potentially bordering on Maysir (gambling/excessive speculation) in financial reporting, but the standard's requirement for "reliable basis" and disclosure aims to mitigate this risk. The previous Shariah expert correctly identified this as primarily an accounting matter not impacting contract validity.
Overall, the proposals represent a necessary and generally Shariah-compliant evolution of FAS 10 to cover modern intangible assets and services. They build upon the existing Shariah permissibility of Istisna'a for such items (Footnote 7) and seek to provide practical guidance while attempting to maintain adherence to the principle of minimizing Gharar regarding the subject matter.
Concerns:
- Subjectivity in Defining Al-Masnoo' and Mitigating Gharar for Complex Intangibles: While Proposal 1 attempts to adapt the definition criteria and allows for phased specifications, the assessment of whether the initial contract definition for a complex, novel intangible asset (like advanced software or a specific AI capability) is "sufficiently defined initially" to "remove material Gharar" remains highly subjective. Unlike tangible goods where quality and quantity can be objectively measured, the functional output, performance, and scope of complex intangibles can be difficult to define precisely at contract inception, potentially leading to significant Gharar regarding what Al-Masnoo' will ultimately be delivered. The reliance on subjective assessment of "sufficient clarity" could lead to disputes or contracts being entered into with a level of uncertainty that contravenes the fundamental Shariah requirement for the subject matter to be known.
- None.
Recommendations:
- To mitigate the subjectivity and potential Gharar issues identified in Concern 1, Proposal 1 should be strengthened by requiring specific contractual mechanisms for complex intangible Istisna'a contracts. This could include mandating clear, measurable acceptance criteria or performance benchmarks tied to specific milestones defined at contract inception, even if the detailed functional specifications are phased. The standard should emphasize that the contract, not just internal documentation, must contain sufficient detail or a clear framework for how the final Al-Masnoo' will be verified against agreed-upon parameters to ensure Gharar is adequately addressed from the outset.
- None.
Analysis:
The proposed enhancements to AAOIFI FAS 10 represent a crucial and timely update to address the application of Istisna'a contracts to intangible assets and services. The existing standard is clearly geared towards tangible goods, leading to significant ambiguities in accounting for modern contracts involving software development, digital platforms, and bespoke services. The proposals aim to bridge this gap by providing specific guidance while staying within the fundamental framework of Istisna'a and established accounting principles for long-term contracts.
Proposal 1: Guidance on Defining Al-Masnoo' for Intangible Assets and Services From a financial accounting and reporting perspective, clearly defining Al-Masnoo' is foundational. It underpins the ability to recognize costs incurred as 'Istisna'a work-in-progress' (as referenced in Document 1, paras 4, 5, and Document 2, para 19). Without a well-defined subject matter, it's difficult to justify accumulating costs related to its creation. The proposed adaptation of the Kind, Type, Quality, and Quantity criteria for intangibles, with relevant examples (software, services, performance metrics), provides the necessary basis for this recognition. Furthermore, the definition of Al-Masnoo' is critical for measuring the stage of completion, which is essential for applying the Percentage-of-Completion (PoC) method (Document 3). A vague subject matter makes reliable progress measurement impossible. Acknowledging phased specifications for complex intangibles is practical, aligning with modern development methodologies, provided the initial scope is sufficiently clear to establish the core asset being created and provide a basis for initial cost accumulation and progress measurement. This clarifies what costs are being capitalized towards a specific, identifiable output.
Proposal 2: Clarification of Istisna'a Costs for Intangible Asset Creation This proposal directly addresses a key accounting measurement issue. The current exclusion of "research and development costs" (original text, para 2/1(a)) is problematic when the core contracted activity for an intangible asset is development. Capitalizing costs "specifically undertaken as an integral part of the contracted process of creating Al-Masnoo'" for intangibles is consistent with the principle of accumulating all directly attributable costs necessary to bring an asset to its intended state and location. This aligns the accounting treatment of Istisna'a work-in-progress (Document 1, 2) for intangibles with the economic reality of the contract. It differentiates between general R&D (which adds to general knowledge and is typically expensed) and project-specific development (which directly contributes to the contracted asset). This is a necessary clarification to ensure the 'Istisna'a work-in-progress' asset reflects the true cost of production under the contract.
Proposal 3: Guidance on Percentage-of-Completion Method for High Uncertainty Projects This proposal focuses on revenue and profit recognition. The PoC method is generally preferred in accounting standards for long-term contracts as it provides a more timely and relevant representation of performance over the life of the contract, compared to the Completed-Contract Method (CCM) (Document 3). The current standard's reliance on "reasonable accuracy" for cost estimation as a condition for PoC can be restrictive for complex intangibles. The proposal acknowledges this inherent uncertainty but allows PoC if "reliable methods" for measurement and estimation can still be established. This is a pragmatic approach that encourages institutions to develop robust internal systems for tracking progress and costs on intangible projects. Disclosure of the methods used is crucial for transparency, allowing users to understand the basis for profit recognition in inherently uncertain projects. This strikes a balance between relevance and prudence, allowing PoC where estimation uncertainty is managed, but requiring CCM where it is not. It directly impacts the timing and amount of profit reported in the statement of comprehensive income and the valuation of Istisna'a work-in-progress (Document 2, Example 3).
Proposal 4: Explicit Section for Istisna'a of Intangible Assets and Services This proposal is primarily structural but highly beneficial from a user perspective. Explicitly including intangible assets and services in the main body of the standard, rather than just a footnote, significantly improves clarity and usability. A dedicated section consolidating the specific accounting considerations for intangibles makes the standard more accessible and highlights its applicability to a wider range of modern transactions. It provides a logical home for the specific guidance proposed in the other enhancements regarding Al-Masnoo' definition, cost inclusion, measurement of progress, and revenue recognition for intangibles. This enhances the standard's overall effectiveness and reduces the likelihood of misinterpretation or oversight when dealing with intangible Istisna'a contracts.
Overall, these proposals are well-integrated and build upon each other. They address key accounting challenges related to recognition, measurement, and reporting for intangible Istisna'a contracts, adapting the existing FAS 10 principles to a modern context while referencing and clarifying concepts like Istisna'a costs and work-in-progress valuation already present in the standard (Documents 1, 2).
Concerns:
- Subjectivity in Cost Capitalization for Intangibles (Proposal 2): While the proposal correctly identifies that development costs integral to the contracted intangible asset should be capitalized, the distinction between these costs and excluded "general research and development activities not directly attributable" can be highly subjective in practice. This is particularly challenging in iterative or agile development environments common for intangibles, where activities might contribute to both the specific contracted output and reusable components or general knowledge. This subjectivity could lead to inconsistent application across institutions and potentially distort reported asset values and profits if not accompanied by clearer guidance or examples.
- Assessing "Reliable Basis" and "Reasonable Accuracy" for PoC (Proposal 3): The assessment of whether "reliable methods" can be established for measuring progress and estimating costs, and thus meeting the criteria for "reasonable accuracy" for applying the Percentage-of-Completion method to complex intangibles, remains highly judgmental. Without more specific guidance or examples tailored to different types of intangible development (e.g., software vs. digital content vs. bespoke service platforms), the interpretation of "reliable" could vary significantly. This could result in premature or overly optimistic profit recognition in some cases, undermining the prudence principle.
Recommendations:
- Provide comprehensive implementation guidance or illustrative examples within FAS 10 or an accompanying implementation guide to clarify the application of Proposal 2, specifically detailing how to distinguish between capitalizable project-specific development costs and non-capitalizable general R&D or overheads in the context of intangible asset creation under Istisna'a. This guidance could reference typical activities in software development or other intangible creation processes and link them explicitly to the contractual scope and specifications.
- Enhance the disclosure requirements in Proposal 3 by requiring institutions to disclose not only the methods used for cost estimation and progress measurement for complex intangible Istisna'a contracts but also the key assumptions underlying those estimates and the impact of changes in those assumptions on reported profit and work-in-progress valuation. This increased transparency would provide users with better insight into the inherent uncertainties and management judgments involved.
Analysis:
The proposed enhancements to AAOIFI FAS 10 represent a crucial and necessary adaptation of the standard to the evolving landscape of Islamic finance, particularly its application to intangible assets and services like software development and bespoke digital services. The existing standard is primarily structured around tangible manufacturing, leading to significant ambiguity when applied to modern Istisna'a contracts for intangibles.
Proposal 4, which suggests introducing a dedicated section for intangible assets and services, is a fundamental structural improvement. Elevating the applicability to intangibles from a footnote (as currently in the Juristic Rules section) to a prominent place in the main body of the standard significantly enhances clarity and signals the standard's broader scope. This new section serves as a valuable hub, consolidating the specific considerations required for intangible Al-Masnoo' and providing a logical framework for the other proposed amendments. It directly addresses the issue of the standard being perceived as solely applicable to tangible goods.
Proposal 1 directly tackles the core contractual requirement of defining Al-Masnoo'. The adaptation of the "Kind, Type, Quality, and Quantity" criteria with relevant examples for intangibles (software, services, performance metrics, user capacity) is essential for practical application. The inclusion of guidance on applying these criteria via "functional specifications, performance standards, technical requirements, scope definitions, and milestones" is highly relevant to intangible development. Acknowledging phased specifications for complex projects, provided the initial framework mitigates Gharar, aligns the standard with common industry practices for intangible creation while attempting to maintain Shariah compliance regarding the subject matter definition at contract inception. This proposal significantly improves the clarity and applicability of a fundamental section of the standard for intangible Istisna'a.
Proposal 2 addresses a critical accounting aspect by clarifying the treatment of costs. The current blanket exclusion of "research and development costs" is inappropriate for intangible Istisna'a where the contracted activity is essentially development. The proposed modification to include R&D-like activities that are "specifically undertaken as an integral part of the contracted process of creating Al-Masnoo' when Al-Masnoo' is an intangible asset or service" provides a more accurate reflection of the cost of production for such assets. This aligns the standard's cost accumulation principles with the economic reality of intangible creation and improves the reliability of the reported Istisna'a work-in-progress value. The distinction between general R&D and project-specific development is crucial and the proposal attempts to draw this line.
Proposal 3 provides much-needed guidance on revenue and profit recognition for complex intangible projects. The inherent estimation uncertainty in such projects makes the application of the Percentage-of-Completion (PoC) method challenging under the current "reasonable accuracy" requirement. The proposal acknowledges this but allows the use of PoC if reliable estimation and progress measurement methods can be established, shifting the focus to the robustness of the institution's systems and processes rather than solely the nature of the asset. This promotes the use of the PoC method where appropriate, providing more timely and relevant financial information, while retaining the prudence of using the Completed Contract Method when reliability cannot be demonstrated. Requiring disclosure enhances transparency regarding the significant judgments involved.
Overall, the proposals demonstrate a coherent approach to adapting FAS 10 for intangibles, building upon the existing structure and principles. They improve clarity, enhance structural organization (especially Proposal 4), and aim for consistency with the economic substance of intangible creation and modern project management practices, while seeking to remain consistent with the underlying Shariah requirements. The retrieved excerpts on cost, loss recognition, and disclosure (Documents 1, 2) highlight the context of cost accumulation and measurement, which are directly impacted and clarified by Proposals 1, 2, and 3.
Concerns:
- Subjectivity in Defining Intangible Specifications and Assessing Gharar (Proposal 1): While the proposed adaptations for Kind, Type, Quality, and Quantity for intangibles are helpful, the subjective nature of terms like "functional specifications," "performance validation," and assessing whether the "overall framework and core requirements are sufficiently defined initially" for complex, novel intangibles remains a significant concern. This subjectivity could lead to inconsistent application across institutions regarding the level of detail required at contract inception to mitigate material Gharar, potentially resulting in disputes or uncertainty about contract validity from a Shariah perspective.
- Distinguishing Capitalizable Development Costs (Proposal 2): The clarification differentiating integral development costs from general R&D is necessary, but the practical application of "specifically undertaken as an integral part of the contracted process" versus general development efforts (e.g., platform improvements, reusable component development) can be highly subjective in complex, iterative, or agile development environments. This lack of clear boundaries could lead to inconsistencies in cost capitalization, impacting reported profit and asset values.
Recommendations:
- For Proposal 1, add implementation guidance or illustrative examples (perhaps in an appendix) detailing what constitutes "sufficiently clear" initial specifications for complex intangible projects with phased definitions. This guidance should reference specific types of contractual clauses, documentation (e.g., detailed scope documents, high-level architecture designs, key performance indicators), and milestones that can demonstrate sufficient clarity regarding the expected functional outcome and performance characteristics at contract inception to mitigate material Gharar.
- For Proposal 2, provide more detailed guidance or case studies within the standard (or an accompanying implementation guide) illustrating the distinction between capitalizable development costs directly attributable to the contracted intangible Al-Masnoo' and excluded general research or development costs. This could include criteria related to traceability of costs to specific contract deliverables, the stage of the development lifecycle, and how costs for reusable components or platform enhancements developed concurrently with a specific contract should be treated.
Okay, Standards Validator Agent online. I will evaluate the proposed enhancements to AAOIFI FAS 10 based on the specified criteria.
Here is the validation report:
Proposed Enhancement 1: Guidance on Defining Intangible Subject Matter (Al-Masnoo')
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Shariah Compliance Assessment (Core Islamic Finance Principles & FAS 10 Specific Principles):
- Analysis: The core Shariah principle at play here is the prohibition of Gharar (excessive uncertainty). FAS 10 Para 4/1/1 requires Al-Masnoo' to be "known and specified to the extent of removing any lack of knowledge" regarding its Kind, Type, Quality, and Quantity. This is explicitly aimed at mitigating Gharar (referenced in the original text footnote 10 related to 3/3). The proposed enhancement does not alter the requirement for specification to remove uncertainty. Instead, it provides guidance on how to apply the existing criteria (Kind, Type, Quality, Quantity) to intangible assets and services, using relevant terms (Nature/Kind, Scope/Type, Key Features/Functionality/Quality, Deliverables/Quantity). The proposal explicitly states the level of detail should be sufficient to clearly define scope and outcome, mitigating Gharar.
- Conclusion: Complies with Shariah principles. It upholds the fundamental requirement of specifying the subject matter to mitigate Gharar, adapting the application method for modern intangible assets without compromising the underlying principle.
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Consistency Check (FAS 10 Internal & Other Standards):
- Analysis: The proposal directly modifies Para 4/1/1, building upon the existing structure. It also acknowledges and aligns with Footnote 7 (which currently allows for services/intangibles). It provides a practical interpretation of existing rules for a new context (intangibles). This enhances the standard's applicability without creating internal contradictions. Consistency with other standards like FAS 4 (Musharaka) which acknowledges intangible assets as capital contribution (requiring valuation) is also maintained, as the focus here is on defining the asset for Istisna'a manufacturing/acquisition purposes.
- Conclusion: Consistent with FAS 10 and related standards. It clarifies and expands the application of an existing rule to a subject matter already implicitly allowed.
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Practical Implementation Assessment:
- Analysis: The proposed guidance provides concrete examples and categories (Nature/Kind, Scope/Type, Key Features/Functionality/Quality, Deliverables/Quantity) that are directly applicable to defining intangible assets like software or AI platforms in commercial contracts. This is how such projects are typically scoped. The original text's examples (car, house) are not practical for intangibles. The proposed text makes the standard practically applicable to a significant and growing area of economic activity.
- Conclusion: Provides practical guidance and is implementable.
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Reasoning: This proposal effectively addresses the ambiguity of applying tangible-focused specification criteria to intangible assets. By adapting the criteria while maintaining the core requirement of mitigating Gharar, it ensures Shariah compliance and makes the standard relevant for modern Istisna'a contracts involving software, AI, and services.
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Decision: APPROVED.
Proposed Enhancement 2: Clarifying Istisna'a Costs for Intangible Asset Creation
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Shariah Compliance Assessment (Core Islamic Finance Principles):
- Analysis: Cost definition in accounting standards is primarily an issue of financial reporting accuracy and transparency, not a direct Shariah prohibition like Riba, Gharar, or Maysir. Shariah principles require fairness and truthful representation in financial dealings. Excluding costs that are integral and specifically required to produce the contracted Al-Masnoo' (even if they involve development-like activities) would lead to an inaccurate representation of the asset's cost and the contract's profitability, potentially violating the spirit of transparency and fairness. The proposal clarifies that costs specifically and directly attributable to producing the contracted intangible are part of Istisna'a costs. This aligns cost recognition with the economic reality of creation.
- Conclusion: Complies with Shariah principles. It supports the principle of transparent and fair financial reporting by ensuring that costs integral to the production of the contracted asset are properly accounted for.
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Consistency Check (FAS 10 Internal & Other Standards):
- Analysis: The proposal modifies Para 2/1(a) by refining the exclusion of R&D costs. It interprets "research and development costs" in the context of intangible creation, distinguishing between general R&D and project-specific development costs. This is a common distinction made in accounting for internally generated intangible assets (though Istisna'a is a contract manufacturing scenario). The proposed text aligns the accounting treatment with the economic substance of creating a bespoke intangible asset under contract. It doesn't contradict other parts of FAS 10 regarding cost recognition or revenue recognition methods; it clarifies which costs are included.
- Conclusion: Consistent with FAS 10 and general accounting principles regarding cost recognition for asset creation.
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Practical Implementation Assessment:
- Analysis: Distinguishing between project-specific development costs and general R&D can be challenging but is a standard requirement in accounting for software development projects (e.g., based on phases like feasibility, design, coding, testing). The proposal provides a clear criterion: costs must be "specifically and directly required for the production of the contracted Al-Masnoo'". This is implementable through robust project cost tracking and allocation systems.
- Conclusion: Provides practical guidance and is implementable, albeit requiring careful cost tracking.
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Reasoning: This proposal addresses a critical accounting issue for intangible-based Istisna'a contracts. The blanket exclusion of R&D costs in the original text is inappropriate for contracts whose core activity is the "development" of a specific intangible. The proposed clarification allows for accurate cost measurement, supporting fair financial reporting.
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Decision: APPROVED.
Proposed Enhancement 3: Considerations for Percentage-of-Completion with High Uncertainty
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Shariah Compliance Assessment (Core Islamic Finance Principles):
- Analysis: The choice of revenue recognition method is primarily an accounting policy matter. Shariah requires that financial reporting is not misleading. Recognizing revenue/profit under the Percentage-of-Completion method requires a reliable basis for estimating progress and total costs. If estimates are genuinely unreliable (Gharar in estimation), using this method could lead to misleading financial statements. The original text's requirement for "reasonable accuracy" addresses this by mandating the Completed-Contract method when accuracy is lacking. The proposed change replaces "reasonable accuracy" with "sufficient reliability to provide meaningful financial information". This shift in terminology, coupled with the requirement for robust processes and reassessments for high-uncertainty projects, does not introduce Gharar into the underlying transaction or the recognized profit, provided the estimates are indeed sufficiently reliable and the process is robust. It aims to ensure the recognized profit reflects the substance of the progress made, which aligns with transparency.
- Conclusion: Complies with Shariah principles. It maintains the principle that estimates must be reliable enough to avoid misleading reporting, while providing a more nuanced definition of reliability and acknowledging the nature of complex projects.
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Consistency Check (FAS 10 Internal & Other Standards):
- Analysis: The proposal directly modifies Para 2/3/1/1 and Appendix (E). It retains the core principle that the Percentage-of-Completion method requires reliable estimates and mandates the Completed-Contract method otherwise. The change in wording ("sufficient reliability to provide meaningful financial information" vs. "reasonable accuracy") and the added context for high-uncertainty projects provide flexibility and clarify the application criteria without fundamentally altering the accounting policy options or their underlying conditions. It aligns the standard's language closer to modern accounting concepts of relevance and faithful representation.
- Conclusion: Consistent with FAS 10's overall approach to revenue recognition, clarifying the conditions for applying the Percentage-of-Completion method in complex scenarios.
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Practical Implementation Assessment:
- Analysis: Determining "sufficient reliability" for complex, high-uncertainty projects is inherently challenging. However, the proposal links this determination to practical project management requirements like "robust project management processes, detailed initial scoping... and regular, documented reassessments". These are standard practices for managing risk and tracking progress in complex IT/software projects. While judgment is still required, the proposal provides a framework for making that judgment and supporting it with documented processes. It offers a practical alternative to being forced into the Completed-Contract method solely due to the inherent nature of the project, allowing for potentially more relevant reporting.
- Conclusion: Provides practical, albeit challenging, guidance that is implementable with appropriate project management discipline.
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Reasoning: This proposal appropriately addresses the difficulty of applying a strict "reasonable accuracy" standard to innovative, high-uncertainty projects common in intangible asset creation. By focusing on "sufficient reliability for meaningful information" and linking it to robust processes, it allows for the application of the Percentage-of-Completion method when justified by project controls, leading to more relevant financial reporting, while still requiring the Completed-Contract method when uncertainty is prohibitive.
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Decision: APPROVED.
Proposed Enhancement 4: Integrating Intangible Subject Matter Allowance into Main Body
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Shariah Compliance Assessment (Core Islamic Finance Principles):
- Analysis: Moving text from a footnote to the main body is an issue of standard structure and presentation, not Shariah compliance. The underlying permissibility of intangible subject matter (already established by the footnote) is consistent with Shariah, as Istisna'a is based on Istihsan and Maslaha (public good/common need) and does not contravene core prohibitions, even if the subject matter is non-existent at the time of contract. This proposal simply makes this established point more prominent.
- Conclusion: Complies with Shariah principles (no impact on Shariah compliance; it only improves the accessibility of an already Shariah-compliant allowance).
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Consistency Check (FAS 10 Internal & Other Standards):
- Analysis: This proposal significantly improves the internal consistency and clarity of FAS 10. It elevates a fundamental aspect of the contract (what can be the subject matter) from a footnote to the main definition, providing a clear foundation for the subsequent accounting treatments, especially those related to intangibles (as clarified in Proposals 1, 2, and 3). Creating dedicated sections/sub-sections for intangibles provides a logical structure for the specific guidance needed for such assets. This aligns the standard's structure with its intended scope (including intangibles).
- Conclusion: Highly consistent with FAS 10 and improves its structure and usability.
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Practical Implementation Assessment:
- Analysis: Moving text and creating new sections is a straightforward editorial/structuring change. It makes the standard more practical to use by clearly indicating that intangible assets are within scope and providing a designated place for rules specific to them.
- Conclusion: Highly practical and easily implementable.
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Reasoning: Placing the fundamental allowance for intangible assets and services in a footnote is a structural weakness in the current standard, diminishing its perceived scope and making it harder to locate relevant guidance. Integrating this into the main body and providing dedicated sections for intangible-specific considerations (building on the other proposals) significantly enhances the standard's clarity, usability, and relevance for modern Islamic finance transactions.
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Decision: APPROVED.
Overall Validation Decision:
All four proposed enhancements are well-reasoned, address critical issues in applying FAS 10 to modern intangible assets and services, maintain compliance with Shariah principles (by adapting application rather than altering core rules), enhance consistency within the standard, and provide practical guidance. They collectively improve the standard's relevance and applicability in the contemporary financial landscape.
Final Decision: APPROVED.
Detailed Feedback:
The proposed enhancements represent a significant and necessary update to AAOIFI FAS 10 to accommodate intangible assets and services as Al-Masnoo'.
- Proposal 1: Successfully translates the Shariah requirement of specifying the subject matter (Al-Masnoo') to mitigate Gharar into practical terms for intangibles. The examples provided are highly relevant.
- Proposal 2: Correctly identifies that the blanket exclusion of R&D costs is problematic for intangible asset creation under Istisna'a. The proposed clarification to include costs specifically required for the contracted asset aligns accounting with economic reality and supports transparent reporting.
- Proposal 3: Provides a more flexible and relevant criterion for applying the Percentage-of-Completion method by focusing on "sufficient reliability for meaningful information" and linking it to robust project management. This acknowledges the inherent uncertainty in complex projects while ensuring estimates are still reliable enough for reporting purposes, consistent with Shariah principles of fairness and avoiding misleading information.
- Proposal 4: Essential for the structural integrity and usability of the standard. Moving the allowance for intangibles/services from a footnote to the main body provides a clear foundation for the specific rules and considerations proposed in the other enhancements.
Together, these proposals ensure FAS 10 remains relevant for innovative Islamic finance structures involving intangible assets while adhering to core Shariah principles and accounting objectives.
The proposed enhancements to FAS 10 primarily focus on modernizing the standard to explicitly and comprehensively address Istisna'a contracts for intangible assets and services. This involves providing detailed guidance on specifying the subject matter, clarifying cost recognition (particularly for R&D-like activities integral to production), and offering more flexible criteria for applying the percentage-of-completion method to high-uncertainty projects. These changes aim to reduce ambiguity (Gharar), ensure appropriate cost and revenue recognition, and improve the relevance of financial reporting for such transactions.
The analysis of the impact on other selected standards is as follows:
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Impact on FAS 4 (Musharakah and Mudarabah):
- Synergies: FAS 4 already acknowledges that Musharakah capital can be in the form of real or intangible assets (Appendix D). The proposed detailed guidance in FAS 10 (Proposal 1) on how to specify intangible assets (Kind, Type, Quality/Features, Quantity/Deliverables) provides a useful conceptual framework that could inform how intangible assets contributed as Musharakah capital are described and agreed upon by partners, thereby upholding the FAS 4 requirement that capital be "known, specified and agreed". Proposal 4, by integrating intangible subject matter into the main body of FAS 10, reinforces the broader principle within AAOIFI standards that intangible assets are valid subjects of Islamic finance contracts.
- Contradictions: There are no direct contradictions. FAS 4 deals with partnership capital and profit/loss sharing, while FAS 10 deals with the creation and sale of a specific asset. The accounting treatments are distinct.
- Overall: The impact is primarily synergistic at the conceptual level regarding the treatment and specification of intangible assets, rather than affecting core Musharakah accounting.
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Impact on FAS 7 (Zakat):
- Synergies: None directly apparent, as FAS 7 is a standard for Zakat calculation, relying on asset and liability values determined by other FAS standards.
- Contradictions: No direct contradictions.
- Overall: The proposed changes in FAS 10 have an indirect impact on FAS 7. By clarifying the definition of Istisna'a costs for intangible assets (Proposal 2) and potentially allowing for earlier profit recognition through the percentage-of-completion method (Proposal 3), the carrying value of Istisna'a assets (work-in-progress or completed assets) and the reported profit/retained earnings will be affected. These values are inputs into the Zakat calculation under FAS 7. An increase in Zakat-able assets or profit due to the new FAS 10 guidance would lead to a higher Zakat liability. FAS 7 relies on the asset values and profits reported under other FAS, so changes in FAS 10 directly influence the basis for Zakat calculation, although FAS 7's principles of calculation remain unchanged.
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Impact on FAS 28 (Murabaha and Other Deferred Payment Sales):
- Synergies: Both standards require the subject matter to be known and specified to minimize Gharar. While FAS 28's requirements are generally simpler as it deals with existing or acquired assets, the detailed approach to specifying intangibles in the enhanced FAS 10 (Proposal 1) could conceptually inform the level of detail expected if Murabaha were ever applied to the sale of highly specific, complex intangible assets (though Murabaha is less typical for purely intangible assets compared to tangible goods).
- Contradictions: There are no direct contradictions. Murabaha involves the sale of an existing asset, while Istisna'a involves the creation of an asset. The accounting treatments (cost of acquisition vs. cost of production, revenue recognition methods) are fundamentally different.
- Overall: The impact is low. The core principles and accounting methods are distinct, with minimal overlap beyond the basic requirement for subject matter specification.
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Impact on FAS 32 (Ijarah and Ijarah Muntahia Bittamleek):
- Synergies: None directly apparent. FAS 32 deals with leasing the usufruct of an asset, while FAS 10 deals with creating an asset.
- Contradictions: There are no direct contradictions. The nature of the transactions and the accounting treatments are fundamentally different (lease accounting vs. production/sale accounting). While Ijarah can apply to the usufruct of intangible assets (like software licenses), FAS 32's focus is on the lease arrangement itself, not the creation of the underlying intangible asset.
- Overall: The impact is low. The standards address different types of contracts with distinct accounting requirements.
| Standard ID | Impact Level | Impact Type |
|---|---|---|
| FAS 4 | Medium | Synergy |
| FAS 7 | Medium | Dependency |
| FAS 10 | High | N/A |
| FAS 28 | Low | Synergy |
| FAS 32 | Low | None |
- Cross-Referencing for Intangible Asset Specification: In the Basis for Conclusions or relevant sections of FAS 4, consider adding a cross-reference to the detailed guidance on specifying intangible assets provided in the enhanced FAS 10 (specifically the proposed changes to 4/1/1). This would provide helpful guidance for institutions when intangible assets are contributed as Musharakah capital.
- Review FAS 7 Implications: While FAS 7 relies on values from other standards, the Accounting Board should review the potential impact of the enhanced FAS 10 (specifically Proposals 2 and 3) on Zakat calculations. Consider adding commentary or examples in FAS 7's Basis for Conclusions or implementation guidance to clarify how intangible assets valued under the new FAS 10 rules (and potentially intangible assets held as Musharakah capital under FAS 4) should be treated for Zakat purposes, ensuring consistency with the principles of Zakat on trade goods or similar assets.
- Consistent Terminology for Intangibles: Ensure that the terminology used for intangible assets and services is consistent across all AAOIFI standards where they are mentioned as subject matter, capital, or leased assets.
- Highlight Principle Alignment: Explicitly mention in the Basis for Conclusions of the enhanced FAS 10 how the detailed guidance on specifying intangibles aligns with the fundamental Islamic finance principle of mitigating Gharar, reinforcing its relevance across various contract types.