2.1. Introduction
Murabaha is a
cost-plus profit sale contract whereby disclosure of cost to the buyer is
necessary. Under Murabaha arrangement customer requests to the Islamic
Financial Institution (IFI) to purchase an asset for him (customer) and sell on
deferred payment. An essential feature of Murabaha is that IFI must purchase
the required commodity from supplier first and then sell to the customer. Bank
charges a certain profit usually linked with Inter Bank Offered Rate. Recovery
could be agreed in installments or Balloon payment. Amount of installment or
price of the asset cannot be (stipulated) increased or decreased in case of
default or early payment (Shari’a standard 8). In order to create pressure on
client for prompt payment a penalty is imposed upon customer as agreed in
Murabaha contract. Amount of penalty for default in prompt payment recovered,
cannot be included in income of IFI in any case and must be spent for charity
(Usmani, 2002). Murabaha has successfully replaced the overdraft and short term
loans facility under conventional banking. Murabaha is dominant
mode of financing in portfolios of IFIs since the inception of Islamic banking due to its
easiness in practice and low risk as compared to profit and loss sharing modes
of financing.
Comparative study of conventional and Islamic
financial system reveals following important points as for rights, liabilities,
risks and rewards of the parties concerned. If client goes for conventional
fiancé he will get simply Rs; 6,000,000 loan in cash form for a charge of 10%
interest assuming same return as for Islamic bank. By the time loan approved
and available to customer an asset of 6 million is created as loans receivables
by conventional bank and another Liability of current deposit is created of
equal amount while cash and balances decrease as and when amount is withdrawn.
Conventional bank has no risk in this transaction except default on behalf of
customer. After expiry of one month
interest revenue of Rs; 50,000 is due hence form the income of conventional
bank. Asset (loan receivables) increased by Rs; 50,000 while liability of
customer is also increased by Rs; 50,000.
Under normal circumstances conventional bank has not
much concern whether computers purchased or not. His interest is in return of
principal as well as interest hence linkage of financial sector with real
sector is not guaranteed. What could be the impact of this transaction if
loaned money has not gone into production process? On one hand income is increasing
while on the other hand goods and services are not increasing consequently more
income and less goods and services, hence leading to higher prices for goods
and services (inflation) in the economy. In case of default by customer on due
date loan can be rescheduled generally by charging a little higher rate of
interest e.g 11% in this transaction.
On the other hand rights, liabilities, risks and
reward are much different under Islamic financial system. When customer
contacted for purchase of computers although IFI consented to provision of
financing but no rights and liabilities affected. When computers purchased in
the name of IFI it increased the risk exposure of bank being owner of goods
carrying number of risks including destruction, damage, obsolescence, theft,
fire, transportation etc. and finally refusal by customer to accept as he has
not an agreement to purchase, with bank, rather a promise to purchase. On the
next stage goods sold to customer and now IFI is at par in risk of default with
conventional bank. Profit of Islamic bank is due by the date Murabaha sales taken
place however as customary and keeping in view the nature of baking (where
deposits are changing hands frequently) it is spread over period of Murabaha
transaction. No profit can be assumed by IFI until sales of goods to customer
has taken place.
As per principle of Murabaha IFI will not
pay amount of Rs; 6 million to customer rather payment is made or current
account is opened in the name of vendor hence ensuring the use of funds for the
purpose these are requested and guaranteed linkage of financial
sector to the real sector hence zero contribution of this transaction in
inflation. Finally rescheduling of Murabaha receivables is not allowed and IFI
cannot extend period by charging at higher interest rate or at same rate. IFI
can take legal action for recovery or auction the security held in extreme
cases. Generally IFI does not want to lose the customer for a minor default and
Ulema (clerics) has allowed to incorporate a penalty section in contract of
Murabaha in case of default by customer subject to use of penalty is only for
charity and must not be included in income of IFI.
One must understand & appreciate nature of
penalty imposed by IFI on customer. It is not extra charge like conventional
banking which is rent of money paid late by customer. It is to penalize the
defaulter and encourage prompt payment. Even then if default is committed and
penalty is charged, amount recovered under penalty head is not the income of
IFI. Difference lies here in use of penalty amount by IFI and extra interest
earned by conventional bank. Former is using recovered amount for charity and
not increasing his income while later is treating late payment charges as his
income. It is further pertinent to state that late payment penalty is not the
only solution to encourage prompt payment. If a speedy with easy access
judicial system is in order or a commission to settle default cases is
established financial penalty may not be required in case of default.
2.2. Steps in Murabaha
Murabaha is used
extensively by Islamic Financial Institutions (IFIs) due to its salient
features including low risk and easy settlement. Murabaha financing is completed
in certain steps and those must be adhered to achieve Shari’a compliance. In fact risk bearing is essential for seller to
earn profit hence underlying asset must come into ownership and possession of
IFI. Steps involve in Murabaha are as under. Figure 2.1 depicts Murabaha sale
process.
1. Customer requests to an IFI for purchase of an
asset. IFI gets written promise from customer to purchase the asset once it is
acquired by IFI.[written promise]
2. IFI purchases asset as per specifications of
customer from vendor. [Purchase order]
In
certain exceptional cases where IFI is lacking in technical expertise relating
to purchase of an asset, she can appoint another person as a purchasing agent
including the customer himself. Appointing customer as purchasing agent could
be fruitful for both customer and IFI because asset is purchased for customer
and his satisfaction can be ensured if he is the purchasing agent. However at
this stage customer is only agent to IFI and underlying asset belongs to IFI.
All risks of ownership are borne by IFI. (e.g. asset suffers any damage without
negligence of agent it is the loss of IFI and not of the customer). Once asset
is being purchased agent will inform to IFI. Asset at this stage is in ownership
and possession of IFI [I & II].
3.
Asset is purchased by IFI and possession taken over, physical or constructive
[Invoice in the name of IFI].
4.
Payment is made by IFI to vendor. In no case payment should be handed over to
customer, even if asset is directly acquired by customer as agent of IFI from
vendor. [Cash or cheque in the name of vendor]
5.
After acquisition of asset offer to purchase by customer or offer to sell by
IFI is made which becomes a sale contract on the acceptance by the other party.
Asset is transferred to the ownership and possession of customer along with all
risks and returns of ownership [Murabaha sale agreement].
Under
certain exceptional circumstances asset is transferred directly to premises of
customer by vendor but in this case still risk of ownership is responsibility
of IFI until asset is being sold to customer [III –V].
6.
Payment is made by customer to IFI either lump sum or installments as the case
may be [Cash or cheque(s) in the name of IFI].
Figure
2.1. Graphic presentation of Murabaha sales process
2.3. Summary of Standard [FAS-2]
1. Assets possessed by Islamic bank for the purpose
of selling them on the basis of Murabaha or Murabaha to the purchase orderer
shall be measured at the time of acquisition on an historical cost basis. After
acquisition of assets if there is a decline in value of the assets held for
sale on Murabaha following two options are suggested depending upon the
underlying circumstances:-
a. If asset is acquired for a customer with binding
promise, no adjustment is required.
b. If asset is acquired for a customer without
binding promise, then an appropriate adjustment to the cost should be made.
Cost of Murabaha includes
payment due to supplier plus direct expenses (transportation, insurance,
storage, fee for letter of credit) incurred. Operating expenses of bank must
not be included in cost. Any discount received from supplier even after
execution of Murabaha contract must be passed on to customer. Cost and profit
must be certain at the time of sale[1].
It is permitted to sell the asset on Bai al Bara’ah (sale on ‘as is’ basis)
relieving the IFI from any manufacturing defect of asset, however, in this case
right of recourse to manufacturer should be assign to customer. Urboun (earnest money) is allowed after
execution of Murabaha contract. However it is preferred to forfeit the amount
equal to actual loss suffered [SS 8].
1. Mr. Khan entered into a binding promise to
acquire a machine from Margalla Islamic bank after arrangements made by bank.
It was agreed to use Murabaha sales instrument for the deal with 12% margin on
actual cost. Bank purchased the machine from vendor for PKR 600,000 and spent
50,000 on transportation and 30,000 on insurance in transit. Cost of this asset
is PKR 680,000 and selling price is PKR 761,600 with 12% profit.
2. Alam Zeb entered into a binding promise with
local Islamic bank to acquire a machine costing PKR 500,000. Bank arranged the
machine from vendor and kept in godown. After passing 15 days market value of
machine declined by 10%. As bank has agreed with customer to charge KIBOR plus
1% on Murabaha sale, hence no adjustment is required to the cost of asset.
However if Alam Zeb has not signed a binding promise then an adjustment of PKR
50,000 [500,000 X 10%] is required and now carrying value of machine is only
PKR 450,000.
2. If any discount is received by Islamic bank on
the price of an asset sold or to be sold under Murabaha, the same should be
passed on to the customer by reducing the cost of the underlying asset(s).
1. Mr. Khan requested bank to purchase a machine for
him from Germany and supply to customer under Murabaha sale at 10% profit.
Machine was imported by Mr. Z and charged to bank PKR 1,000,000. Price of this
contract would be PKR 1,100,000. Suppose after completion of deal importer gave
2% discount to bank, it is necessary that bank reduce the selling price even
after completion of sales transaction. Hence now cost is PKR 980,000
[1,000,000-20,000] and selling price is 1,078,000 [1,100,000-22,000].
3. Murabaha receivables are to be recorded at face
value at the time of sale irrespective whether these are long term or short
term. However receivables are measured at cash equivalent value [amount due
less any provision for doubtful accounts].
1. Mr Zahoor entered into a deal with an IFI to
purchase a motor vehicle. Cost of vehicle is PKR 1,500,000 and profit of 20%
was agreed on cost, payable in four equal installments due at the end of six
months. Selling price of this deal is PKR 1,800,000 and sales as well as
accounts receivable of PKR 1.8 million should be recorded in books of accounts.
However if at the time of closing if bank considers to create 5% provision for
doubtful accounts, the same shall be shown as deduction from accounts
receivables.
4. Profit on Murabaha sale is to be recognized as
follow according to circumstances:-
a. If it is cash sales or credit sales recoverable
within the accounting period at the time of sales
b. If it is credit sales with expected/agreed
recovery beyond the single accounting period irrespective whether in
installments or a single payment, proportionate allocation of profits over the
period of the credit whereby each financial period shall carry its portion of
profits irrespective of whether or not cash is received.
In both of the cases mentioned above sales and costs
shall be recognized at the time of contract subject to deferral of profits
under case b. At the time of closing any deferred profit shall be shown as
deduction from Murabaha receivables.
1. Mr. Sharik entered into a Murabaha sales with a
local Islamic bank for purchase of raw cotton amounting to PKR 500,000 with 5%
profit on cost payable within 6 months. This transaction shall be recorded as
sales of PKR 525,000 with a realized profit of PKR 25,000 if period falls
within the same accounting period.
2. Mr. Yahya entered into a Murabaha sale agreement
with Margalla Islamic bank for purchase of cement plant costing PKR 30 million.
Profit on sales agreed is 20%. Amount is payable in four equal installments,
due within six month interval. Price of this sale is PKR 3,600,000 with an
amount of PKR 900,000 per installment. Profit on deal is PKR 600,000. As this
deal is beyond one accounting period, hence profit should be spread over all
accounting periods. Let us assume these 24 months fall is three accounting periods
[6 months in first accounting period; one year in second accounting period; and
six months in third accounting period] hence, profit should be distributed as
PKR 150,000 in first period; PKR 300,000 in second accounting period and PKR
150,000 in third accounting period. It is further suggested that sale and cost
should be recognized in first accounting period with deferred profit of PKR
450,000 [300,000+150,000] for second and third accounting periods. If first
installment is received in time then closing balance of accounts receivables
would be PKR 2,250,000 [2,700,000-450,000] after making adjustment for deferred
profit.
5. If any rebate is allowed, due to early payment by
the customer, at the time of payment to customer, the same is deducted from
accounts receivables as well as from deferred profit.
6. It is permitted to demand security deposit (Hamish Jiddiya) from customer in case of
binding promise which can be forfeited equal to the amount of actual loss
suffered by bank (excluding time value of money) if customer breaches his
promise.
There are two types of security deposits; one is
security against a promise [Hamish Jiddiya] and second is against a sales
agreement [Urboun]. Hamish Jiddiya cannot be forfeited in full, only actual
loss can be recovered. Urboun can be forfeited in full irrespective of loss of bank;
however it is preferred to recover the actual loss only.
1. Mr. Khan requested bank to purchase a machine for
him from Germany and supply to customer under Murabaha sale at 10% profit.
Machine was imported by Mr. Z and charged to bank PKR 1,000,000. Price of this
contract would be PKR 1,100,000. Suppose while Murabaha sales agreement was
signed a security deposit of PKR 200,000 agreed by parties which can be
forfeited by bank in case of non performance of sales contract by Mr. Khan.
However it is preferred that bank sell the asset to another party and if could
not recover the original price paid [PKR 1,000,000 in this case] the difference
may be charged to Mr. Khan.
2. Mr. A requested to an IFI to arrange a machine
for him on deferred sale basis. As per agreement both agreed to charge profit
of 10% per annum and payment would be due after one year. As goods are not
available with bank and has to arrange from market, hence contract of sales
cannot be executed, so Mr. A promised to purchase once the goods arranged by
bank and paid PKR 50,000 as security deposit. After the goods arranged by bank
Mr. A shown lack of interest in execution of sales agreement. Bank disposed of
goods for cash at a loss of PKR 20,000. Mr. A is obliged to reimburse the
actual loss of bank, hence bank is required to refund only 30,000 out of
security deposit to Mr. A after deducting the actual loss. Suppose goods value
was PKR 1,000,000 and it was agreed to sell to Mr. A at PKR 1,100,000, still loss accounted for under
Islamic financial system is only PKR 20,000 and not 120,000 [100,000 loss of
expected profit and 20,000 loss from actual spending]. Suppose further bank
entered into another Murabaha with Mr. B for 1,080,000 and lost expected profit
of PKR 20,000. In this case nothing shall be deducted from security money
deposited by Mr. A as bank lost nothing from cost [no actual loss]. Loss of
expected profit of PKR 20,000 is not to be reimbursed by Mr. A under Islamic
financial system.
3. Mr. Khan requested to Margalla Islamic Bank to
arrange raw material for his factory amounting to PKR 500,000 and promised to
enter into Murabaha agreement once the goods arranged. After acquisition of
bank Mr. Khan was not interested in sale agreement and bank had to dispose of
goods at 10% loss to Mr. Alam. Mr. Khan is responsible to reimburse loss of PKR
50,000 to bank. Suppose bank and Khan were agreed to a profit of 20% through
this Murabaha deal and non performance of promise put the bank on loss of
expected profit. This expected profit cannot be charged to customer under
Islamic financial system and bank can claim damages equal to actual loss from a
defaulter of promise.
7. The bank should disclose in the notes to
financial statements whether it considers the promise made in the Murabaha to
purchase orderer as obligatory or not.
2.4.
Bookkeeping
In this section journal entries relating to Murabaha
sales are illustrated:
1. When a customer enters into a binding promise to
purchase the goods once arranged by bank and deposits a security (Hamish
Jiddaya) the following journal entry is passed.
Journal
Date
|
Description
|
L/F
|
Debit
|
Credit
|
2013
Jan. 12
|
Cash
Customer account
Amount deposited by customer to
be used either advance payment or Hamish Jiddaya.
|
50,000
|
50,000
|
|
Total
|
50,000
|
50,000
|
2. When the asset is purchased by bank from the
vendor and direct expenses are incurred following journal entries are recorded
in the books of accounts.
Journal
Date
|
Description
|
L/F
|
Debit
|
Credit
|
2013
Jan. 15
Jan. 17
Jan. 17
|
Murabaha Assets
Accounts Payable
Asset purchased from vendor for
Murabaha to purchase orderer.
Carriage Inwards
Insurance in Transit
Cash
Amount paid for direct expenses
Murabaha Assets
Carriage inwards
Insurance in transit
Direct expenses transferred to Murabaha
asset.
|
500,000
15,000
5,000
20,000
|
500,000
20,000
15,000
5,000
|
|
Total
|
540,000
|
540,000
|
3. When Murabaha sales agreement is signed and
ownership as well as possession of goods transferred to customer the following
journal entries are recorded.
Journal
Date
|
Description
|
L/F
|
Debit
|
Credit
|
2013
Jan. 20
Jan. 20
|
Murabaha Receivables
Murabaha Asset
Deferred profit
Murabaha sale executed
Customer account
Cash
Security deposit is refunded
|
594,000
50,000
|
520,000
74,000
50,000
|
|
Total
|
644,000
|
644,000
|
Note:
1. In case security deposit is used as partial
payment of price, no entry is required.
2. In case amount is neither taken back by customer,
nor used as partial payment of price then bank has to open two accounts for the
same customer. One account for Murabaha financing; and the other as investment
(PLS) account carrying the rights of rab ul maal (partner with capital).
4. When an installment is paid by customer the
following entry is passed.
Journal
Date
|
Description
|
L/F
|
Debit
|
Credit
|
2013
Jun. 20
|
Cash
Murabaha Receivables
Amount of installment under Murabaha
sale received
|
100,000
|
100,000
|
|
Total
|
100,000
|
100,000
|
5. At the time of closing accounts receivables are
estimated reliably and provision for doubtful accounts is created -if required-
to record the provision for bad debts following entry is passed. Also profit
needs to be adjusted. Suppose 18,000 profit relates to current period based
upon length of Murabaha sales term.
Journal
Date
|
Description
|
L/F
|
Debit
|
Credit
|
2013
Jun. 30
Jun. 30
|
Income Summary
Provision for doubtful ac counts
3% of accounts receivables reserved for
doubtful accounts
Deferred Profit
Income Summary
Part of profit realized.
|
14,820
18,000
|
14,820
18,000
|
|
Total
|
32,820
|
32,820
|
6. Following would be balance sheet presentation of
foregoing transactions relating to Murabaha sales.
Partial Balance Sheet
Assets
|
Notes
|
Amount
|
Murabaha Receivables
Less-Provision for Doubtful accounts 14,820
Deferred Profit 56,000
Net Murabaha Receivables
|
19
|
494,000
(70,820)
424,180
|
7. Suppose customer could not honor his commitment
to purchase the asset and disposed off for an amount of 496,000, resulting in a
loss of 24,000 [520,000-496,000]. This loss shall be reimbursed by Murabaha to
purchase orderer and the following entry would be passed.
Journal
Date
|
Description
|
L/F
|
Debit
|
Credit
|
2013
Jan. 30
|
Cash
Customer account
Murabaha Asset
Murabaha asset disposed off at
a loss which is recovered from purchase orderer.
|
496,000
24,000
|
520,000
|
|
Total
|
520,000
|
520,000
|
2.5. Financial Impact
of Murabaha
Financial reporting and financial impact of Murabaha are discussed
in following paragraphs. I shall illustrate with a hypothetical balance sheet
and show the impact on balance sheet of an IFI of different transactions under
Murabaha. Balance sheet of an IFI is
little different from balance sheet of a conventional bank in the sense that
IFIs accept deposits 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 customer and IFI. Deposits under profit and
loss sharing (PLS) modes including Musharaka & Mudaraba are not shown as
liabilities in the balance sheet of an IFI rather reported as equity. On the
other hand conventional banks lend money and shows advances to customers as
asset while IFIs are not lending cash rather sell the goods on credit hence
resulting in receivables under Murabaha, Muajjal etc. Furthermore IFIs are
investing in businesses who need cash financing under schemes of Musharaka &
Mudaraba hence investment under Musharaka &
Mudaraba is shown as asset and not the receivables or advances. Let us look at a
simple balance sheet of an IFI as at December 31, 2009.
Cash and balances include cash in branches, balances
with other banks and reserve with central bank. Accounts receivables include
receivables under Murabaha, Ijarah, Bai Muajjal, Bai Salam and
Istisna’a. Short term investments are investments made in stocks and Sukuk
while PLS investments include investments made under Musharaka, Diminishing Musharaka and Mudaraba. Property plant and equipment are the physical
assets of bank used in business process and not held for sale (e.g. furniture,
building, motor vehicles etc.). On liabilities side payable include payments to
the vendors and balances payable to other banks. Accrued expenses are day to
day expenses due but not paid. Equities consist of two types including deposits
under profit and loss sharing and owners equity. Statutory reserve is required
by law for banks to maintain equal to their paid up capital and retained
earnings are undistributed profits.
ABC
Islamic Bank Ltd
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
|
1,000
1,000
500
200
150
2,850
1,000
2,000
|
Liabilities
Payables and balances
Current deposits
Accrued expenses
Total
liabilities
Equities
PLS deposits balances
Shareholders’
equity
Paid up capital
Statutory reserves
Retained earnings
Total
Equities
|
400
300
50
750
1,500
3,000
400
200
5,100
|
Total
assets
|
5,850
|
Total
liabilities & Equities
|
5,850
|
Now we are ready to understand the impact of any
Murabaha transaction. To illustrate a customer walked
in bank on January 1st 2010, with a request to supply 100 computers
of specified brand on one year credit and signed the promise to purchase as and
when supplied by bank within period of one month. What is affect of this
agreement on bank’s balance sheet? Answer is nothing as it is simply promise
not an agreement of sale and purchase which carries rights and liabilities.
Suppose bank is demanding earnest money of Rs; 200,000 to guarantee the
seriousness of customer in the form of current account deposit to be maintained
till the deal is finalized and customer provide the deposits. What is affect of
this transaction is shown in following condensed balance sheet.
Journal
Date
|
Description
|
L/F
|
Debit
|
Credit
|
2010
Jan. 1
|
Cash
Customer account
Security deposit for Murabaha investment
received.
|
200,000
|
200,000
|
|
Total
|
200,000
|
200,000
|
ABC
Islamic Bank Ltd
Balance
sheet, as at January 1, 2010.
Assets
|
Rs (000)
|
Liabilities
& Equities
|
Rs (000)
|
Cash and balances
Others from earlier B/S
|
1,200
4,850
|
Current deposits
Others from earlier B/S
|
500
5,550
|
Total
assets
|
6,050
|
Total
liabilities & Equities
|
6,050
|
Suppose in order to ensure quality and desired
specification bank appoint the customer as agent to visit another city and
purchase computer on behalf of bank. Expenses incurred amounting to Rs; 50,000
during purchases process and deal is finalized between bank and supplier of
computers @ Rs; 60,000 per computer on 10th of January 2010.
Expenses incurred by customer are reimbursed by bank as expenses of agent are
always borne by principal. Suppose instead of agreeing to make payment to the
vendor in cash customer relations department of bank succeeded in getting
current deposit from the vendor for its branch in the city of vendor and opened
a current account of vendor. Impact of
the transaction is displayed in following balance sheet. Both sides of balance
sheet current deposits (liability) and inventory (asset) increased by 6
million; and cash decreased by PKR 50,
000 as well as inventory increased by 50,000 as these are direct expenses to be
included in cost of Murabaha assets.
Journal
Date
|
Description
|
L/F
|
Debit
|
Credit
|
2010
Jan. 10
Jan. 10
|
Murabaha Assets
Vendor account
Asset purchased and payment of cost
made available to customer.
Murabaha Asset
Cash
Expenses incurred on purchase of
Murabaha assets
|
6,000,000
50,000
|
6000,000
50,000
|
|
Total
|
6,050,000
|
6,050,000
|
ABC
Islamic Bank Ltd
Balance
sheet, as at January 10, 2010.
Assets
|
Rs (000)
|
Liabilities
& Equities
|
Rs (000)
|
Cash and balances
Murabaha Assets-Inventory
Others from earlier B/S
|
1,150
6,050
4,850
|
Current deposits
Others from earlier B/S
|
6,500
5,550
|
Total
assets
|
12,050
|
Total
liabilities & Equities
|
12,050
|
On January 15, 2010, customer and bank exchanged
offer and acceptance documents, hence sale executed. Selling price agreed Rs; 6,996,000 consist of
cost plus 10% profit payable at the end of December, 2010. It is irrelevant, as
for validity of Murabaha agreement is
concerned, whether goods are delivered first to bank and then transported to customer
or directly delivered to customer by shipping company. What is required is to
borne the risk of ownership by bank being seller to the customer. Risk of loss
or damage is borne by bank till the delivery of goods to customer at a place
which is agreed between parties. If that place is ex-factory of vendor then
bank is responsible for loss between periods of 10th to 15th
January 2010, and if delivery point is customer premises then bank is
responsible till the time goods delivered to the customer. By 17th
January, 2010, goods delivered to customer without any damage at his premises
by shipping company. For transporting goods bank incurred further expenses of
transportation amounting to PKR 250,000 and Insurance in transit PKR 60,000. Price
of Murabaha sales calculated as under table 2.1.
Table
2.1 Price Calculation of Murabaha Sales
|
Impact of this transaction is shown in following
balance sheet.
ABC
Islamic Bank Ltd
Balance
sheet, as at January 17, 2010.
Assets
|
Rs (000)
|
Liabilities
& Equities
|
Rs (000)
|
Cash and balances
Murabaha Receivables
Others from earlier B/S
|
840
6,996
4,850
|
Current deposits
Deferred profit
Others from earlier B/S
|
6,500
636
5,550
|
Total
assets
|
12,686
|
Total
liabilities & Equities
|
12,686
|
Journal
Date
|
Description
|
L/F
|
Debit
|
Credit
|
2010
Jan. 15
Jan. 17
Jan. 17
|
Murabaha Assets
Transportation expenses P/A
Takaful expenses P/A
Expenses payable on transportation
of Murabaha assets recorded.
Murabaha R/A
Murabaha Asset
Deferred Profit
Sales of Murabaha assets executed
at 10% margin on cost.
Transportation expenses P/A
Takaful expenses P/A
Cash
Transportation expenses paid.
|
310,000
6,996,000
250,000
60,000
|
250,000
60,000
6,360,000
636,000
310,000
|
|
Total
|
7,616
|
7,616
|
Note the change on both sides. Cash and balances decreased
due to payment of Rs; 310,000 as expenses of insurance and transportation.
Inventory of computers finished and Murabaha receivable
generated with a profit of Rs; 636,000 which is disclosed as deferred profit to
be realized by December 31, 2010, irrespective whether amount received at due
date or not. Suppose amount received at December 31, 2010 and in the mean time
vendor, who is depositor of bank as well, has withdrawn 50% of the balance,
also original deposit of security PKR 200,000 adjusted. Following balance sheet
has shown the impact of all transactions relating to this particular Murabaha
sale.
Journal
Date
|
Description
|
L/F
|
Debit
|
Credit
|
2010
Dec. 31
Dec. 31
Dec. 31
|
Customer account
Vendor account
Cash
50% of amount withdrawn by
vendor and security deposit withdrawn by Murabaha customer.
Cash
Murabaha Asset
Amount of Murabaha receivables
recovered.
Deferred profit
Retained earnings
Profit realized on Murabaha.
|
200,000
3,000,000
6,996,000
636,000
|
3,200,000
6,996,000
636,000
|
|
Total
|
10,832
|
10,832
|
ABC
Islamic Bank Ltd
Balance
sheet, as at December 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
|
4,636
1,000
500
200
150
6,486
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
836
5,736
|
Total assets
|
9,486
|
Total liabilities & Equities
|
9,486
|
Illustration.1. Mr. Abdullah requested to Meezan
bank Islamabad on January 1st 2010, to issue cash for purchase of
cotton amounting to Rs; 2 million payable in four equal six monthly
installments. Meezan bank agreed to the deal by charging 10% profit. Meezan
bank appointed Mr. Abdullah as agent to visit the cotton belt and finalize purchase
of cotton as per required quality. Mr. Abdullah spent amounting to Rs; 50,000
in searching and purchasing the required commodity of cotton. On January 10th
2010, Mr. Abdullah made the deal with broker (Mr. Omer) in Veharri in the name
of Meezan Bank. On January 15, 2010, offer and acceptance completed between Mr.
Abdullah and Meezan bank at Islamabad office of Meezan bank. As per desire of
Mr. Abdullah cotton is to be supplied by Meezan bank at factory premises
located in industrial estate Hattar. Punjab Sarhad goods transport company
hired by Mr. Abdullah on behalf of Meezan bank to transport cotton bales from
Melsee (Godown of Mr. Omer) to Hattar (Factory of Mr. Abdullah) for shipping
charges of Rs; 200,000. Transportation insurance/takaful amounting to Rs;
20,000 paid to Pak Qatar Takaful Company.
Cotton: A cash
crop in Pakistan
Required:-
1. Will Meezan bank pay the required
cash of Rs; 2 million to Mr. Abdullah?
2. Who will bear the transportation and
cost of living amounting to Rs; 50,000 spent by Mr. Abdullah?
3. Who will pay the cost of
transportation and insurance/takaful of cotton bales shifted from Melsee to
Hattar?
4. What is the cost of this transaction
to be used to calculate profit?
5. What is selling price and amount of
profit?
6. What is amount of profit realized
annually? Quarterly? Monthly?
7. Journalize the above transactions as
per FAS-2 issued by AAOFIF.
Solution
1. No as per Murabaha principles bank is trader who purchases the
goods from vendor and sells to customer hence receive cash from customer and
pay to vendor. Meezan bank should not make payment to Mr. Abdullah rather pay
directly to vendor.
2. Mr. Abdullah is working in capacity
of agent for bank hence all expenses incurred relating to purchase of asset are
required to be borne by Meezan bank. If it is not the fee for services rendered
then it can be treated as direct expense to be included in cost of goods sold
under Murabaha sales.
3. As per agreement Meezan bank is
required to supply the goods at factory premises of customer hence
transportation cost is to be paid by bank. During this period any damage to the
inventory is charged to bank and/or insurance company as the case may be
however whole risk is of bank and not the customer.
4.
Direct
costs incurred relating to inventory are used in calculation of cost including
payment or payable to vendor and transportation including insurance. Cost of
goods for charging profit is calculated as under table 2.2.
Table 2.2. Calculation of cost of
goods sold
|
||||||
5.
Selling
price calculated by adding 10% margin on cost of goods sold as under (table
2.3).
Table 2.3
calculation of selling price
|
6. Because it is two years deal hence
prorata share of profit is Rs; 113,500 for each year. Quarterly profit is Rs;
28,350 and monthly profit is Rs; 9,458. As In banking sector depositors are
free to deposit and withdraw except fixed PLS deposits hence de-annualisation
of profit is necessary to quarter or to month for servicing depositors.
7. Following are the relevant journal
entries:
Journal
Date
|
Description
|
L/F
|
Debit
|
Credit
|
2010
Jan. 10
Jan. 15
Jan. 15
Jul. 15
Dec. 31
|
Murabaha Assets
Accounts Payable
Transportation expenses P/A
Takaful expenses P/A
Miscellaneous expenses
Cost of goods and Expenses
payable on transportation of Murabaha assets recorded.
Accounts payable
Transportation expenses P/A
Takaful expenses P/A
Miscellaneous expenses
Cash
Cost of goods and other direct
expenses paid.
Murabaha R/A
Murabaha Asset
Deferred profit
Murabaha sales executed at 10%
margin on cost.
Cash
Murabaha R/A
First Installment received.
Deferred Profit
Income summary
Portion of profit realized.
|
2,270,000
2,000,000
200,000
20,000
50,000
2,497,000
610,500
113,500
|
2,000,000
200,000
20,000
50,000
2,270,000
2,270,000
227,000
610,500
113,500
|
|
Total
|
7,761,000
|
7,761,000
|
Note:
It depends upon policy of bank whether to prepare
income statement for profit distribution on monthly, quarterly, semiannually or
annually, hence adjusting entry for profit realization shall be made
accordingly.
Illustration.2.
In Continuity of illustration 1, in order to ensure the prompt payment
Meezan bank inserted a clause in Murabaha agreement
that a penalty of 10% of amount due
shall be imposed if default continued for a period of 30 days from due date.
Required:-
1. What is amount of penalty if first
installment is paid on 10th of August 2010? 30th of
August 2010?
2. What is impact of penalty recovered
on revenue, assets, liabilities and equity of Meezan bank?
Solution
1. Due date for first installment is six month July
15th 2010, from date of sale January 15th 2010. As per
agreement grace period is 30 days hence penalty shall be imposed after 15th
of August 2010. If amount is paid on 10th of August 2010, no penalty
is imposed. However in case payment is made on 30th August 2010,
penalty equal to 10% of amount due is charged. Amount due on first installment
is calculated as under. Following are given two methods of calculation first
based on time value and second ignoring time value. Selection of method is very
vital in transaction as it determines the rights and liabilities of parties
concerned. Time value of money concept has not been accepted in Islamic financial
literature hence use of first method in practice of Islamic banking is not
recommendable. First is traditional method of installment calculation by
applying following formula:
Where P is
the amount spent on inventory, R is
the installment, I is the interest
rate and n is the number of years and
m is number of compounding in a year.
This formula is based on concept of time value of money hence not recommended
for use in Islamic modes of financing. As per this formula if we calculate four
equal six monthly installments amount of each installment becomes approximately
Rs; 626,000 rounded to 100.
Second method is based on simple calculation by
ignoring time value of money. While ignoring the time value of money, it is
simply division of selling price calculated in part 5 of illustration 1 hence,
amount of each installment is Rs; 610,500. Second method of calculation is
recommended. Consequently amount of penalty is Rs; 61,050.
2. Amount of penalty cannot form part of income of
Meezan bank and role of bank is only to act as trustee for collection and
distribution of charity. It will not affect financial position of bank at all.
However as a matter of disclosure in financial statements it is shown as
increase in cash on asset side and increase in charity fund on liabilities side
of balance sheet.
Journal
Date
|
Description
|
L/F
|
Debit
|
Credit
|
2010
Aug.30
|
Cash
Murabaha R/A
Charity fund
1st installment
along with penalty received.
|
671,550
|
610,500
61,050
|
Illustration.3. Continuing through illustration
1& 2. In order to mitigate the risk
of default by Mr. Abdullah, Meezan bank demanded security and customer offered
the ownership paper of a plot in Defense with estimated market value of Rs; 3
million, to be auctioned in case of default for amount due for a period of more
than one year. Mr. Abdullah made the first payment on 10th of August
2010, second installment by February 10th of 2011, but could not
make the last two installments till 15th January 2013 and not sure
when to be able to make payment in foreseeable future. He informed the Meezan
bank accordingly. Plot was auctioned by Meezan bank on April 25, 2013 for
amounting to Rs; 3,500,000. For auction of plot Meezan bank had to incur
expenditures amounting to Rs; 100,000.
Required:-
1. What is the impact on financial
reporting of Meezan bank, if any, of receiving and retaining ownership paper of
plot from customer as security?
2. What is amount of penalty received
with first installment and second installment?
3. What is amount of penalty due with
third installment and fourth installment?
4. How much amount is to be refunded to
Mr. Abdullah, if any, on sale of plot?
Solution
1. Holding ownership paper of plot as security does
not affect financial position or revenues of Meezan bank. However this fact
must be disclosed in notes that Murabaha receivables
are secured hence risk of default is mitigated.
2. Because both installments are within grace period
so no question of charging penalty.
3. Amount of penalty is equal in both installments
amounting to Rs; 61,050. One must appreciate the fact that penalty is different
from late payment charges as charged under conventional banking. Late payment
charges of installment three and four are not equal under conventional banking
because time period of default is larger for third installment as compared to
fourth.
4. Selling price of plot is Rs; 3,500,000. Meezan
bank can claim only actual receivables and amount spent on disposal of plot and
not the time value of money for delay in recovery of approximately one and half
years in first installment and one year in second installment. Hence, amount
refunded to Mr. Abdullah is calculated as under.
Table 2.4 calculation
of refundable amount
|
Journal
Date
|
Description
|
L/F
|
Debit
|
Credit
|
2010
Jan. 10
Jan. 15
Jan. 15
Jul. 15
Dec. 31
2011
Feb. 10
Dec. 31
2013
Apr. 25
Apr. 25
Apr. 25
Apr. 25
|
Murabaha Assets
Accounts Payable
Transportation expenses P/A
Takaful expenses P/A
Miscellaneous expenses
Cost of goods and Expenses
payable on transportation of Murabaha assets recorded.
Accounts payable
Transportation expenses P/A
Takaful expenses P/A
Miscellaneous expenses
Cash
Cost of goods and other direct
expenses paid.
Murabaha R/A
Murabaha Asset
Deferred profit
Murabaha sales executed at 10%
margin on cost.
Cash
Murabaha R/A
First Installment received.
Deferred Profit
Income summary
Portion of profit realized.
Cash
Murabaha R/A
Second installment received
within the grace period.
Deferred profit
Income summary
Profit realized for 2nd
year.
Cash
Customer account
Security sold for cash.
Customer account
Cash account
Selling expenses of security
paid.
Customer account
Murabaha R/A
Charity fund
Two installments recovered and
penalty amount deposited in charity fund account.
Customer account
Cash
Excess amount refunded to customers.
|
2,270,000
2,000,000
200,000
20,000
50,000
2,497,000
610,500
113,500
610,500
113,500
3,500,000
100,000
1,343,100
2,056,900
|
2,000,000
200,000
20,000
50,000
2,270,000
2,270,000
227,000
610,500
113,500
610,500
113,500
3,500,000
100,000
1,221,000
122,100
2,056,900
|
|
Total
|
15,485,000
|
15,485,000
|
2.7. Comparison with
Conventional Accounting
In this section a comparison of conventional Vs
Murabaha accounting is presented to establish following points:
1. Conventional accounting carries insufficient
guidance to cover Murabaha accounting
2. If IFIs follow conventional accounting (due to
local legal framework) then how results are different from Murabaha accounting
In order to understand the difference let us have a
brief example. Mr. Abdullah is a manufacturer of textile goods and frequently
needs working capital from banks. At present he is in need of PKR 2 Million to
purchase raw cotton payable in quarterly eight equal installments. He has two options
including conventional loan and Murabaha financing. Let us further assume that
both conventional as well as Islamic bank is charging the same profit rate of
KIBOR plus one percent [16%]. If we charge straight 16% profit then for two
years period profit on cost becomes PKR 640,000 for two years [this is preferred
as it is eliminating time value of money] and quarterly installment become PKR 330,000,
however as Islamic financial industry knowingly remains competitive with
conventional, hence I calculate installment based upon conventional method
[using time value of money]. Under this method installment becomes PKR 273,019
[which means 4.6% straight]. Following is Analytical table under conventional
accounting.
Analysis of payments under
conventional
Quarters
|
Quarterly
Installments
|
Quarterly
Interest 2%
|
Quarterly
Principal
|
Balance in
Loan
|
0
|
-
|
-
|
-
|
2,000,000
|
1
|
273,019
|
40,000
|
233,019
|
1,766,981
|
2
|
273,019
|
35,340
|
237,679
|
1,529,302
|
3
|
273,019
|
30,586
|
242,433
|
1,286,869
|
4
|
273,019
|
25,737
|
247,282
|
1,039,587
|
5
|
273,019
|
20,792
|
252,227
|
787,360
|
6
|
273,019
|
15,747
|
257,272
|
530,088
|
7
|
273,019
|
10,602
|
262,417
|
267,671
|
8
|
273,019
|
5,348
|
267,671
|
0
|
Total
|
2,184,152
|
184,152
|
2,000,000
|
0
|
Now as per conventional accounting profit varies
from quarter to quarter. In fact it decreases with decrease in payable balance
[starting from 40,000 in first quarter and ending at 5,348 in last quarter]
while under Islamic accounting case is different and profit is spread over the
life of contract. Following is the analytical table under Islamic finance.
Analysis of payment under Islamic
Accounting
Quarters
|
Quarterly
Installments
|
Quarterly
Profit
|
Quarterly
Principal
|
Receivables
Balance
|
0
|
-
|
-
|
-
|
2,000,000
|
1
|
273,019
|
23,019
|
250,000
|
1,750,000
|
2
|
273,019
|
23,019
|
250,000
|
1,500,000
|
3
|
273,019
|
23,019
|
250,000
|
1,250,000
|
4
|
273,019
|
23,019
|
250,000
|
1,000,000
|
5
|
273,019
|
23,019
|
250,000
|
750,000
|
6
|
273,019
|
23,019
|
250,000
|
500,000
|
7
|
273,019
|
23,019
|
250,000
|
250,000
|
8
|
273,019
|
23,019
|
250,000
|
0
|
Total
|
2,184,152
|
184,152
|
2,000,000
|
0
|
Now the issue is that profit under Islamic is
apportioned equally, while under conventional higher earlier and lesser later
on, based upon loan amount. The constraint under Islamic finance is of not
using time value of money; hence return on investment under Islamic finance is
lesser in earlier quarters and higher in later quarters. Let us assume that
there was a default on installment number six for one month. Conventional bank
charged further interest of PKR 2,730 and Islamic bank charged penalty of PKR
2,730. For conventional bank this amount will form part of earnings in eighth quarter
while Islamic bank’s earning will remain same and penalty amount will go into
charity.
The difference in recognition of profit is significant,
and depositors of IFI would suffer in earlier years. Hence we have to follow
conventional accounting in order to be competitive with conventional banks.
This is the practice of current Islamic finance industry to follow accounting –matching-
more with conventional than Islamic due to the hindrance of being competitive
with conventional banks. This can only be taken away if profit rates on
deposits as well as financing may not be matched with conventional fiancé
industry. Also it can be a problem with individual transactions or in short run
only. In longer term revolving amounts would generate to smooth out the
earnings, hence it is suggested to follow profit recognition based upon life of
transaction instead of time value of money method [charging profit linked with
amount of receivables].
[1] Profit charging
must not be tied with any indicator including bank rate (KIBOR). Charging
profit on the basis of KIBOR is allowed at the time of sale however amount of
profit must be settled in Murabaha sale contract. It cannot be stipulated to
change the receivable amount after conclusion of contract based on KIBOR or any
other indicator.
FIGURE 2.1 IS NOT VISIBLE IN YOUR ARTICLE. IF POSSIBLE PLEASE PROVIDE IT.
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