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Bai Salam is a form of sale contract where by IFIs
purchase goods for spot payment with deferred delivery. Practically it is used
in financing of agricultural needs of farmers. Farmers sell their crops prior
to harvesting to IFIs in order to get money to purchase seeds and fertilizers.
Generally spot price agreed is lesser than future prices on the actual date of
delivery, hence IFIs are making profit. As a matter of practice IFIs are
entering into a parallel Salam contract with third party to sell the proceeds
once taken over however execution of second contract is not conditional to the
fulfillment of first contract of Salam (Shari’a standard 10).
Application of Salam as a tool of financing could not get momentum
in the operations of IFIs working in Pakistan in spite of having an agrarian
economy. Share of agriculture in GDP is about 20% while providing jobs to 65%
of the country’s population living in rural areas; however, less than 20% of
seven millions farm households have access to bank financing. Agricultural
sector is vastly underserved as for banking services are concerned and is a
potential market for Salam financing.
Future and forward contracts are very much dominating
the business world. Futures and forwards are sold and purchased for currencies,
stocks, gold, oil and other commodities. How Salam contract is different from futures and
forwards is discussed in following paragraphs. Salam sale can be affected for
only Halal fungible goods which are generally available in the market at the
time of delivery. Physical delivery of goods forming subject matter of Salam
contract is required by Islamic law while in case of futures and forwards
physical delivery is not required. In most of the cases contract is settled on
margins by the parties involved under futures and forwards. This practice of
settling contracts on margins has led to short selling which creates imbalance
in the market by affecting demand and supply of underlying commodity. Under
futures and forwards goods are not sold and purchased rather claims are sold
and purchased which create no utility for the society as a whole. It is zero
sum game where certain individuals gain on the expense of others. Furthermore
future and forward contracts create imbalance in the prices of consumable
commodities (generally moving upward) by creating an artificial demand (e.g.
prices of oil in 2007-08) which affects ordinary users. Two basic features of
Salam sale (immediate payment of price and definite delivery of goods) differentiate
it from futures and forwards.
Salam is used by IFIs to provide agricultural
finance. As in modern economy role of banks is not trader hence they are not
interested to create trading wings. Furthermore national laws are also not
allowing banks to act as traders hence Salam sale contract is another device
used to avoid interest in commercial transactions. Generally, banks after
signing first transaction of Salam, search for a buyer of the goods and enter
into parallel Salam contract. In a complete transaction of modern Salam
contract normally following steps are involved. Figure 3.1 depicts process of
Salam and parallel Salam sales.
1-2. Customer requests to an IFI for finance and sell
the commodity with deferred delivery hence Salam sales contract is executed while payment is
made by bank at spot.
3-4. IFI enters into contract of parallel Salam with another party [usually a whole seller];
receives the payment at spot and signs contract of Salam with promise to
deliver the goods at a point in time in future [usually delivery date from
farmer].
5. At the date of delivery farmer [Seller in first
Salam contract] delivers the goods to IFI to
discharge his liability.
6. IFI delivers the goods to whole seller [buyer in
Parallel Salam contract] hence transaction closed.
Under some exceptional circumstances goods are
directly transferred to whole seller by farmer; however in even in this case
IFI needs to bear risk of ownership till the discharge of liability [V-VI].
Figure
-3.1. Graphic presentation of Salam sales process
FAS-7 is
effective from January 1999, addresses the accounting rules of Salam financing
and parallel Salam transactions. Following is a summary of rules.
1. Salam financing shall be recognized when the
capital of Salam is paid (whether in cash, kind or benefit) to Al-muslam Ileihi
[seller of goods] or when it is made available to him. Parallel Salam
transactions shall be recognized when the Islamic bank receives the capital of
Salam. Capital is measured by the amount paid. Capital provided in kind or
benefit shall be measured at the fair value.
I. ABC bank entered into a Salam contract by making
payment of PKR 100,000 to Bhola, a farmer,
for delivery of 10,000 kgs of wheat at completion of harvesting season.
Salam contract duration is six months. After passing three months, bank sold
the goods to a whole seller under parallel Salam contract for PKR 12/- Per Kg.
On delivery date bank handed over goods to whole seller after taking possession
from Bhola and contract completed.
II. Mr. Bhola contacted a local bank to provide a machine
costing PKR 100,000, to be paid to bank after six months in the form of rice
PKR 50/- per Kg. Bank handed over the required machine for a price of 100,000
[capital of Salam] and signed Salam contract for 2,000 Kgs of rice.
III. Akbar farming and HM bank entered into a Salam
contract of 5,000 tons of rice @ price of 70/- per Kg. for miscellaneous
banking and consultancy services amounting to PKR 350,000 [fair value of
services].
2. At the end of a financial period capital is
measured by the amount paid. However if it is probable that seller will not
deliver the goods in part or in full or it is probable that value of goods to
be delivered will decline, the Islamic bank shall make a provision for
estimated deficit. Parallel Salam transaction shall be presented in the
financial statement as liability.
Mr. Alam entered into a salam contract to supply 1,000
tons of apple to a local IFI for a price of PKR 70/- per Kg. IFI made the
payment to seller immediately. At the time of closing market rate of Salam goods
reduced to 60 and it is expected to prevail till the delivery date, IFI is
required to charge the loss to income summary.
3. Assets received by the Islamic bank in accordance
with the contract are recorded at historical cost. In the case of receipt of a
similar kind of goods, but of a different quality; if the market value of the
received goods is equal to the value of contracted goods, the received goods
shall be measured at book value, however, if the market value is lower, then
the difference shall be recognized as loss [same is the treatment for
substituted goods].
1. Alam khan entered into a Salam contract with an IFI
to supply 2 tons of super Basmati rice after six months @ PKR 80/- per Kg. Bank
made the payment of Salam capital amounting to PKR 160,000. At the time of
delivery seller could not arrange super Basmati rice and offered 2nd
grade Basmati rice equal to 2.3 tons. Market price of 2nd grade is
PKR 70/- per Kg. bank accepted the deal and contract completed.
2. Agha Bank purchased 3 tons of rice from Khan Farms
under Salam sale for a price of PKR 50/- per Kg, for spot payment and deferred
delivery for six months. Bank paid the Salam capital PKR 150,000. At the time
of delivery, customer could not provide the specified rice and offered 6.5 tons
of wheat, which was accepted by the bank. Market price of wheat per Kg is PKR
25/-
4. In case of failure to receive goods at due date and
extension granted to seller, no change in Salam capital. If contract cancelled
and client does not repay the capital of Salam the amount shall be recognized
as receivable due from the client. In case Islamic bank has the securities
pledged for Al-muslam Fihi [Salam goods] and proceeds from sale of the
securities are less than book value of Salam goods, the difference is
recognized as a receivable due from the client. However if proceeds are more
than the book value, then the difference is credited to the client.
I. Raja of Gujar Khan entered into a Salam contract
with local bank to provide 100 tons of wheat grade-II @ PKR 10/- per kg after
six months for an amount of PKR 1 Million, received at spot. At the time of
supply Raja asked for an extension of 30 days. Bank agreed without any change
in required quantity to be supplied.
II. Raja of Gujar Khan entered into a Salam contract
with local bank to provide 100 tons of wheat grade-II @ PKR 10/- per kg after
six months for an amount of PKR 1 Million, received at spot. At the time of
supply Raja could not provide the contracted commodity and contract cancelled
without any charge.
III. Raja of Gujar Khan entered into a Salam contract
with local bank to provide 100 tons of wheat grade-II @ PKR 10/- per kg after
six months for an amount of PKR 1 Million, received at spot. Bank and Raja
agreed to retain paper of plot of Raja as security. At the time of supply Raja
could not provide the contracted commodity and security sold in the open market
for an amount of PKR 2 Million. Bank is required to refund the excess amount.
5. At the end of a financial period, assets acquired
through Salam financing shall be measured at the lower of cost and cash
equivalent value; loss (if any) shall be recognized in income statement.
Bank of Bolan entered into Salam contract with Ch. of
Khanewall for 10,000 bales of cotton @ PKR 1,000 per bale for spot payment with
six months deferred delivery. After passing six month, customer delivered the
required quantity of cotton bales as per specifications. At the time of
closing, it was found that market value is 5% less than the cost. It is
required as per AAOIFI standard to reduce the historical cost by PKR 500,000
[10,000,000 X 5%].
6. Upon delivery of goods by the Islamic bank to the
client in a parallel Salam transaction, the difference between amount paid by
the client and the cost of Salam goods shall be recognized as profit or loss.
On January 1, 2010, Aakash and Margalla bank entered
into a Salam sales contract to purchase 5,000 tons of wheat for a price of
30,000 per ton and Salam capital paid amounting to 150,000,000, delivery to be
made after three months. After passage of 60 days bank entered into a parallel
Salam contract with Khan flour mills for 5,000 tons of wheat to be delivered
after one month for a price of 160,000,000, paid at spot. In this transaction
there is a profit of ten million, however same shall be recognized after
delivery of goods to purchaser in parallel Salam contract i.e. April 2010.
In this section, journal entries are illustrated in
the light of AAOFI financial accounting standard on Salam sale.
1. When a customer contacts an IFI for sale of
intended commodities and IFI agrees to it, no journal entry is required, only a
memorandum entry is made.
2 To record the Salam capital:
I. When Salam capital is paid or made available
following journal entry is passed in the books of accounts. On March 1, 2010,
Mr. Rashid a farmer enters into a Salam contract with a local Islamic bank to
sell one ton (1,000 Kgs) of rice @ 60/- per Kg at the time of harvesting. Bank
released an amount of 60,000 to customer in the hope that rice would sell @
70/- per Kg after taking delivery. The amount of Salam capital is the actual
amount paid and not the expected price of the commodity.
Journal
Date
|
Description
|
L/F
|
Debit
|
Credit
|
2010
Mar. 1
|
Investment
In Salam
Cash
Salam
capital made available to customer
|
|
60,000
|
60,000
|
|
Total
|
|
60,000
|
60,000
|
II. On March 1, 2010, Mr. Rashid a farmer enters into
a Salam contract with a local Islamic bank to sell one ton (1,000 Kgs) of rice
@ 60/- per Kg at the time of harvesting. As per agreement Bank provided a
machine costing 50,000 for a price of 60,000 (fair value) to customer in the
hope that rice would sell @ 70/- per Kg after taking delivery. The amount of
Salam capital is the sales price machine, and not the expected price of the
commodity.
Journal
Date
|
Description
|
L/F
|
Debit
|
Credit
|
2010
Mar. 1
|
Investment
In Salam
Machine
Gain on disposal
Salam
capital paid by supplying a machine.
|
|
60,000
|
50,000
10,000
|
|
Total
|
|
60,000
|
60,000
|
III. On March 1, 2010, Mr. Rashid a farmer enters into
a Salam contract with a local Islamic bank to sell one ton (1,000 Kgs) of rice
@ 60/- per Kg at the time of harvesting. As per agreement Bank provided
miscellaneous services for 60,000 (fair value) to customer in the hope that
rice would sell @ 70/- per Kg after taking delivery. The amount of Salam
capital is the sales price machine, and not the expected price of the
commodity.
Journal
Date
|
Description
|
L/F
|
Debit
|
Credit
|
2010
Mar. 1
|
Investment
In Salam
Service Revenue
Salam
capital paid by providing services.
|
|
60,000
|
60,000
|
|
Total
|
|
60,000
|
60,000
|
2. On April 31st bank entered into a Salam
contract with a local whole seller of rice, for disposal of expected 1,000 Kgs
of rice @ 75/- per Kg to be delivered on September 15 and received the price at
spot. This is a parallel Salam contract meant for disposing of expected
delivery of rice, however as per Islamic financial laws, performance of
parallel Salam contract is not conditional on the performance of original Salam
contract (first contract). It is important to note, that we have three
different prices of underlying commodities are available including a price
negotiated with seller 60/- per Kg; a price we were expecting at the time of
delivery 70/- per when contract executed; and finally a price agreed with
purchaser. However as per AAOIFI standard, the entry shall be made for a price
received from purchaser. There is a
profit of 15/- per kg of rice, but this profit shall be recognized at discharge
of liability by transferring the goods, hence recognition of profit is
postponed. The status of parallel Salam revenue is liability, till the delivery
of goods. Following is the journal entry to record foregoing transaction.
Journal
Date
|
Description
|
L/F
|
Debit
|
Credit
|
2010
Apr. 31
|
Cash
Parallel Salam
Cash
received under parallel Salam of goods to be delivered on September 15, 2010.
|
|
75,000
|
75,000
|
|
Total
|
|
75,000
|
75,000
|
3. At the time closing June 30, 2010 market price of
rice fallen to 55/- per Kg, hence a reduction in the value of intended commodities
is required to be made as under.
Journal
Date
|
Description
|
L/F
|
Debit
|
Credit
|
2010
Jun. 30
|
Loss
on revaluation-Salam
Investment In Salam
Value
of Salam commodities reduced
|
|
5,000
|
5,000
|
|
Total
|
|
5,000
|
5,000
|
4. On September 5, 2010, the delivery date, any of the
following might emerged:
I-Required amount of goods handed over to bank by
customer. As per AAOIFI standard, goods shall be recorded at historical cost.
Journal
Date
|
Description
|
L/F
|
Debit
|
Credit
|
2010
Sep. 5
|
Salam
commodities-Rice
Investment In Salam
Salam
goods received as per agreement.
|
|
55,000
|
55,000
|
|
Total
|
|
55,000
|
55,000
|
Goods received from customer were supplied to purchase
on September 15, 2010 following journal entry is passed.
Journal
Date
|
Description
|
L/F
|
Debit
|
Credit
|
2010
Sep. 15
|
Parallel
Salam
Salam commodities-Rice
Income Summary
Salam
contract closed at profit by supplying goods to purchaser as per agreement.
|
|
75,000
|
55,000
15,000
|
|
Total
|
|
55,000
|
55,000
|
II-Suppose customer could not provide the required
quality of rice and substituted the rice with wheat at an agreed price of 22/-
per Kg (market price 25/- per Kg), and bank accepted 2.727 tons of wheat. On
this deal historical price of Salam capital shall be recorded in books as
market price of supplied goods is higher than contracted goods, following
journal entry is required.
Journal
Date
|
Description
|
L/F
|
Debit
|
Credit
|
2010
Sep. 5
|
Salam
commodities-Wheat
Investment In Salam
Salam
contract closed by exchanging one ton of rice with 2.727 tons of wheat.
|
|
55,000
|
55,000
|
|
Total
|
|
55,000
|
55,000
|
III-In the absence of delivery of rice by customer,
bank purchased the rice from open market @ 70/- per Kg and delivered to purchaser.
Also sold the wheat @ 25/- per Kg, in
the open market. Following entries are required to close the deals.
Journal
Date
|
Description
|
L/F
|
Debit
|
Credit
|
2010
Sep. 15
Sep. 15
Sep. 15
|
Cash
Salam commodities-Wheat
Income summary
Wheat received under Salam contract disposed.
Salam
commodities-Rice
Cash
Goods purchased to be delivered to purchaser
Parallel
Salam
Salam commodities-Rice
Income summary
Goods
delivered under parallel Salam and contract closed at profit.
|
|
68,175
55,000
70,000
75,000
|
55,000
13,175
70,000
70,000
5,000
|
|
Total
|
|
268,175
|
268,175
|
5. In case customer could neither provide contracted
commodities, nor cash; and bank had to sell security. As a rule, if security
sold for an amount not covering cost of contracted goods, balance shall due
from customers, however in case of excess amount on sale of security, the
difference shall be credited to him. Suppose in this transaction there was a
security provided by customer to bank, which sold for 90,000/-; following would
be accounting treatment.
Journal
Date
|
Description
|
L/F
|
Debit
|
Credit
|
2010
Sep. 15
|
Cash
Investment In Salam
Income summary
Rashid-Customer
Salam
contract closed by selling security for 90,000; loss recognized earlier on
Investment in Salam reversed, excess amount credited to customer.
|
|
90,000
|
55,000
5,000
30,000
|
|
Total
|
|
90,000
|
90,000
|
5. Financial Impact of Salam
Financial reporting and financial impact of Salam are discussed in following paragraph. I shall
illustrate with a hypothetical balance sheet and show the impact of different
transactions on balance sheet of an IFI. Balance sheet of an IFI is
little different from balance sheet of a conventional bank in the sense that
IFIs are accepting deposits on either as loan which is in line with practices
of commercial banks and does not create any difference in balance sheet; or on profit
and loss sharing basis under Musharaka and Mudaraba which changes
the nature of relationship between customers and IFIs. Deposits under profit
and loss sharing (PLS) modes including Musharaka & Mudaraba are not shown
as liabilities in the balance sheet rather form part of equity.
On the other hand conventional banks lend money and
show advances to customers as assets while IFIs do not lend cash rather sell
the goods on credit hence resulting in receivables under Murabaha, Muajjal etc. Furthermore IFIs invest in businesses
that need cash financing under scheme of Musharaka & Mudaraba; hence, investment under Musharaka & Mudaraba is
shown as investment and not the receivables or advances. Let us look at a
simple balance sheet of an IFI.
First
Islamic Bank
Balance
Sheet, as at
December 31, 2009
Assets
|
Rs.
(000)
|
Liabilities
& Equities
|
Rs.
(000)
|
Current Assets
Cash and balances
Accounts R/A
Inventory (assets for
sale)
Accrued revenue
Short term investments
Total
current assets
Investments under PLS
Property, plant & equipment
Total
long term assets
|
4,586
1,000
500
200
150
6,436
1,000
2,000
3,000
|
Liabilities
Payables
and balances
Current
deposits
Accrued
expenses
Total liabilities
Equities
PLS
deposits balances
Shareholders’ equity
Paid
up capital
Statutory
reserves
R.
earnings/ Un appropriated
Total Equities
|
400
3,300
50
3,750
1,500
3,000
400
786
5,686
|
Total
assets
|
9,436
|
Total liabilities & Equities
|
9,436
|
Suppose on January 01, 2010, Mr. Shah contacted the
Lahore branch of First Islamic Bank (FIB) to advance Rs; one million for
purchase of seeds and fertilizers for six months to be paid by delivery of 50
tons of wheat by July 30th 2010. FIB agreed to provide required
financing in cash by opening current account of Mr. Shah and prepared Salam sale contract duly signed by both parties on 5th
January, 2010. At the same day account opening form was signed by Mr. Shah. This
transaction has effect on both sides of balance sheet. A current deposit is
generated on liabilities side (consequently current deposits increased by one
million) and an investment under Salam Financing, of equal amount has been
created on assets side.
First
Islamic Bank
Balance
Sheet, as at
January 05, 2010
Assets
|
Rs.
(000)
|
Liabilities
& Equities
|
Rs.
(000)
|
Salam financing
Other assets
|
1,000
9,436
|
Current
deposits
Other
Liabs. & Equities
|
4,300
6,136
|
Total
assets
|
10,436
|
Total liabilities & Equities
|
10,436
|
Suppose on 1st May, 2010, FIB searched
another party Mr. Chaudhary as potential buyer of 50 tons of wheat @ Rs; 21,000
per ton, and enter into parallel Salam of wheat to be delivered on July 31, 2010.
Impact of this transaction is shown as follow. Following balance sheet shows
impact of cash withdrawn by Mr. Shah the seller of wheat to FIB and cash
payment of Mr. Chaudhary the ultimate purchaser from FIB. Withdraw of cash by
Mr. Shah reduced the current deposit while payment of amount by Mr. Chaudhary
shown under the heading of parallel Salam. On the other hand cash reduced by
Rs; 1,000,000 withdrawn by Shah and increased by Rs; 1,050,000 paid by Mr.
Chaudhary.
First
Islamic Bank
Balance
Sheet, as at May 31, 2010
Assets
|
Rs.
(000)
|
Liabilities
& Equities
|
Rs.
(000)
|
Salam financing
Other assets
|
1,000
9,486
|
Current
deposits
Parallel
Salam
Other
Liabs. & Equities
|
3,300
1,050
6,136
|
Total
assets
|
10,486
|
Total liabilities & Equities
|
10,486
|
Now suppose on June 1, 2010 Islamic bank come to know
that prices of wheat has fallen to Rs; 19,000 per ton hence the commodity to be
received has lost a portion of its book value. Current market price is 50,000 X
19 = Rs; 950,000. An immediate write off of loss is required as per accounting
standard on Salam. Impact of this write off is shown
as under. This event affected equities as well as Salam financing by equal
amount because loss in value is charged to equities of Islamic bank
First
Islamic Bank
Balance
Sheet, as at Jun 01, 2010
Assets
|
Rs.
(000)
|
Liabilities
& Equities
|
Rs.
(000)
|
Salam financing
Other assets
|
950
9,486
|
Current
deposits
Parallel
Salam
Other
Liabs. & Equities
|
3,300
1,050
6,086
|
Total
assets
|
10,436
|
Total liabilities & Equities
|
10,436
|
On July 30, 2010, Mr. Shah provided 50 tons of wheat
which handed over to Mr. Chaudhary and shifting expenses (from fields of Shah
to storage of Chaudhary) incurred amounting to Rs; 10,000. Financial impact is
shown below.
First
Islamic Bank
Balance
Sheet, as at July 31, 2010
Assets
|
Rs.
(000)
|
Liabilities
& Equities
|
Rs.
(000)
|
Current Assets
Cash and balances
Accounts R/A
Inventory (assets for
sale)
Accrued revenue
Short term investments
Total
current assets
Investments under PLS
Property, plant & equipment
Total
long term assets
|
4,626
1,000
500
200
150
6,526
1,000
2,000
3,000
|
Liabilities
Payables
and balances
Current
deposits
Accrued
expenses
Total liabilities
Equities
PLS
deposits balances
Shareholders’ equity
Paid
up capital
Statutory
reserves
R.
earnings/ Un appropriated
Total Equities
|
400
3,300
50
3,750
1,500
3,000
400
826
5,776
|
Total
assets
|
9,526
|
Total liabilities & Equities
|
9,526
|
This transaction has affected parallel Salam account, Salam account, cash account (other
assets) and retained earnings account (Equities). In fact bank earned a profit
of Rs; 100,000 and incurred expenses of Rs; 10,000. Cash decreased by Rs;
10,000 while Salam financing account come to an end as well as parallel Salam
account also finished. Let us see the balance sheet as at July 31st
2010.
Suppose Mr. Shah was unable to deliver the goods on
due date and FIB had to acquire the goods from market @ Rs.21, 500 per ton to
deliver to Mr. Chaudhary because under Salam frame work performance of parallel Salam is
independent of Salam contract. FIB has
to suffer loss of Rs; 25,000 plus transportation cost of Rs; 10,000. At this
point in time Salam financing would become receivables from Mr. Shah hence a
profit of Rs; 50,000 realized because FIB reduced the amount of Salam earlier
by Rs; 50,000. Now the original amount becomes receivables due to recovery of
Rs; 50,000 earlier written off. Net result is loss of Rs; 35,000 on this
transaction.
First
Islamic Bank
Balance
Sheet, as at July
31, 2010
Assets
|
Rs.
(000)
|
Liabilities
& Equities
|
Rs.
(000)
|
Current Assets
Cash and balances
Accounts R/A
Inventory (assets for
sale)
Accrued revenue
Short term investments
Total
current assets
Investments under PLS
Property, plant & equipment
Total
long term assets
|
3,551
2,000
500
200
150
6,401
1,000
2,000
3,000
|
Liabilities
Payables
and balances
Current
deposits
Accrued
expenses
Total liabilities
Equities
PLS
deposits balances
Shareholders’ equity
Paid
up capital
Statutory
reserves
R.
earnings/ Un appropriated
Total Equities
|
400
3,300
50
3,750
1,500
3,000
400
751
5,651
|
Total
assets
|
9,401
|
Total liabilities & Equities
|
9,401
|
6. Comparison of IAS Vs FAS
In this section an account of comparison of
conventional and Islamic accounting standards, relating to Salam transactions
are presented. Under conventional framework, no such product of a bank, known
as Salam or similar, exists. Consequently, no guidance about accounting for
Salam financing does exist in international accounting standards framework.
However, as we know, both types of institutions (i.e. conventional and Islamic)
are working in the same business environment, hence, substitutes do exist. In case
of Salam financing, primarily meant for agriculture, whereby IFIs purchase
commodities from farmers, by making spot payment of price, with deferred
delivery of goods; conventional banks extend agricultural loans for interest.
Job of conventional bank is relatively easier as no search for a buyer of Salam
goods is required; as well as no risk bearing of reduction in the prices of
Salam goods; the only risk is credit risk or default risk, which is equally
present in Salam financing for an Islamic banker, in addition to two other
types of risks listed above. In order to understand the difference in
accounting for two types of contracts i.e. Salam financing and agricultural
loan executed by Islamic and conventional banks, respectively, let us look at
an illustration as under.
Iftikhar of Norowaal, a farmer, is in need of PKR
1Million for six months, to purchase the seeds and fertilizer for his multi
hectors of land, situated at the left bank of Upper Chenab Canal. He has two
options i.e conventional and Islamic finances as under.
1.
Conventional loan @ 10% interest
for six months, payable in lump sum at the end of the period.
2.
Salam financing; to sell required
quantity of rice @ 50/- per Kg (expected market price 55-60 after six months)
Following is accounting result, under both
conventional and Islamic accounting assuming contract started on 1st
day of October 2010.
There can be multi-outcomes under Salam financing
contract; however in this section accounting is illustrated based upon
normality of everything. It is assumed that Islamic bank faced the both
additional challenges (finding customer & price risk) as under:
·
At the time of closing
fourth quarter of year 2010, bank made a provision of 2% reduction in the value
of Salam goods.
·
In the mid of March,
Islamic bank succeeded in finding a customer for sale of Salam goods through
parallel Salam, for a price of 1.1 Million.
Following journal completes the recording of
transactions.
Journal
Date
|
Description
|
L/F
|
Debit
|
Credit
|
2010
Oct. 1
Dec. 31
2011
Mar. 15
Mar. 31
Mar. 31
Mar. 31
|
Investment
In Salam
Cash
Salam financing provided to customer in exchange for
20 tons of rice @ 50,000 per ton.
Income
Summary
Provision for reduction in
Salam goods price
2% Provision for reduction in value of Salam goods
is created.
Cash
Parallel Salam
Goods contracted in Salam financing sold in Parallel
Salam
Salam
commodities-Rice
Investment in Salam
Contracted goods in Salam received as per
specification.
Parallel
Salam
Salam Commodities
Income Summary
Goods transferred to purchaser in Parallel Salam as
per contract.
Provision
for reduction in
Salam
goods price
Income Summary
Provision
for reduction in price of rice is no longer required, hence reversed to
income summary account.
|
|
1,000,000
20,000
1,100,000
1,000,000
1,100,000
20,000
|
1,000,000
20,000
1,100,000
1,000,000
1,000,000
100,000
20,000
|
|
Total
|
|
4,240,000
|
4,240,000
|
Note: In the light of foregoing entries, following impact
is found on financial reporting of an Islamic bank due to this Salam contract.
· Income Summary
last quarter of 2010; Nothing earned, but a reduction in the profit by 20,000
· Income Summary
first quarter of 2011; Profit earned on closure of transaction amounting to
100,000 and reversal of provision for price reduction generated another 20,000
credit in income summary, hence Increase in profit by 120,000.
II-Conventional
Accounting
Quarterly earned interest income is 50,000, entries
are recorded as under.
Journal
Date
|
Description
|
L/F
|
Debit
|
Credit
|
2010
Oct. 1
Dec. 31
Dec. 31
2011
Mar. 31
Mar. 31
Mar. 31
|
Advances-Customer
Cash
Agricultural finance is provided to customer for six
months @ 10%.
Interest
R/A
Interest income
Interest income earned for first quarter.
Interest
income
Income Summary
Interest income transferred to income summary
Interest
R/A
Interest income
Interest income earned for 2nd quarter.
Interest
income
Income Summary
Interest income transferred to income summary
Cash
Advances-Customer
Interest R/A
Amount
of agricultural loan received back along with interest income
|
|
1,000,000
50,000
50,000
50,000
50,000
1,100,000
|
1,000,000
50,000
50,000
50,000
50,000
1,000,000
100,000
|
|
Total
|
|
4,240,000
|
4,240,000
|
Note: In the light of foregoing entries, following
impact is found on financial reporting of a bank due to this financing
contract.
· Income Summary
last quarter of 2010; interest income 50,000
·
Income Summary first quarter of 2011; interest income
50,000
Assuming that both banks earned a profit of 1,000,000
in last quarter of 2010 and a profit of 2,000,000 in second quarter of 2011,
except this financing transaction. Following is the net result for both institutions.
Table
3.7.1-Comparative Income Statements (Quarterly)
Description
|
LQ:2010
|
FQ:2011
|
Islamic
Accounting
Profit
other than Salam financing
Provision
for reduction in prices of Salam Commodities
Profit
on Parallel Salam
Reversal
of provision no longer required
Net
Income
Conventional
Accounting
Profit
other than Agricultural finance
Interest
Income
Net
Income
Difference
|
1,000,000
980,000
1,000,000
50,000
1,050,000
-70,000
|
2,000,000
-0-
100,000
2,120,000
2,000,000
50,000
2,050,000
+70,000
|
Under AAOIFI
standards more conservative approach is adopted and profit is postponed, as
well as provision for decline in price is also created, hence results are
totally different from conventional accounting. It is concluded that
application of conventional accounting is not suitable for Salam financing. It
is pertinent to note that adoption of AAOIFI standards should be on immediate
agenda of stakeholders through relevant legislation.
Published in Management Accountant-official Journal of
ICMA-Pakistan [Volume 25 (3)] 2016
· AAOIFI. 2004. Shari’a Standards. P.O. Box 1176,
Bahrain.
· AAOIFI.2003. Accounting
and Auditing Standards for Islamic Financial Institutions, International Institute of Islamic
Economics, Islamabad, Pakistan.
· C.I.I. (1980). Council of Islamic Ideology: Report on
Elimination of Interest from Economy.
· Hanif, M., (2012). Islamic Banking: Theory &
Practice, 2nd edition, Createspace limited liability company,
Amazon.com
· Khan, M.A.,
(1989). Economic Teachings of Prophet Muhammad: A Select Anthology of Hadith Literature
on Economics, chapter 6:2, page 72. International
Institute of Islamic Economics, P.O. Box 1647, Islamabad, Pakistan.
· SBP 2010. [State
Bank of Pakistan] Islamic Banking
Bulletins 2007-2010.
· Usmani, T.S.,
2002.An Introduction to Islamic Finance. Maktaba Ma’arif Al Quran, Karachi,
Pakistan.
