unit 7accountingformurabaha&

8/12/2019 Unit 7AccountingforMurabaha&Amp

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Assoc. Prof. Dr. Shahul Hameed Mohamed Ibrahim

T.A. Shamikh Khan

IE-1002: Reporting of Islamic Financial Transactions

Unit-7Accounting for Sale based transactions-I : Murabaha &

Bai Bithaman Ajil


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Introduction

Concept of sales

Murabaha & Murabaha To Purchase Orderer Shariah Principles & Rules in Murabaha &

MTPO

Recognition & Journal Entries

Measurement of Murabaha Financing Assets& Income Recognition

Problem Illustration

Contents

2


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Introduction

Murabaha or cost plus mark up sale is the first of asset basedfinancing contracts employed by Islamic banks.

It is the most widely used financing instrument as it somehowresembles a loan contract.

In this unit, we will first define murabaha, murabaha to thepurchase orderer.

Then we will discuss the rules and principles of the contractsto understand what accounting entries are needed.

We will then learn the accounting entries on contractinitiation, instalment receipts, revenue recognition,recognition and measurement of assets, and theaccounting treatments for termination, deposits andpenalties.

3


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Concept of Sales

In Islam, Sale can take place in following 3 ways:

On the spotexchange, where the buyer gets the goods and

pays the price to the seller on the spot.

Sale for deferred payment (Bai al muajjal), where theseller sells the goods but the pays the agreed price at a future

date in a full lump sum or in installments over a period.

The buyer pays in advance for an agreed kind, quality,quantify of goods and the seller either makes it to order

(Istisna) or buys or produces it (Salam) and delivers it to the

buyer at a later agreed date.

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Murabaha & Murabaha To The Purchase

Orderer (MTPO)

The bank buys the goods for murabaha sale from the vendor

and pays for it.

The Bank enters into a murabaha contract with a customerand delivers the good.

The customers pay the bank in installments over the contract

period.

5

VENDOR ISLAMIC BANK CUSTOMER

(1)

(3)

(2)

Murabaha transaction:

instalment

Murabaha contract


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Continued

Some Islamic banks such as the Kuwait Finance House

practice this model, in the case of motor car financing.

The bank has warehouses, where it keeps its cars which it has

bought from manufacturers or dealers.

Customer goes to the warehouse and selects a car, informs

the bank & signs a murabaha contract. He drives off with the

car and pays for it later in instalments.

However, most Islamic banks do not want to do this, as it

involves trading and it is risky in the sense that the bank is an

owner of the bought goods and is thus liable for all risks

related to the goods.

Hence, in most cases, Islamic Banks use Murabaha to the

Purchase Orderer which is explained next. 6


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Continued

7

Murabaha To The Purchase Orderer:

VENDOR ISLAMIC BANK CUSTOMER

(2)(1)

(3)

(4)

1. The customer orders the bank to purchase the identifiedgoods, which it promises (this may be binding or nonbinding) to buy from the bank giving it some profit.

2. The bank buys and pays for the goods from the vendor.3. The bank executes a Murabaha contract of sale to the

customer and delivers the goods.

4. The customer pays for the goods on an installment basis tothe bank.


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Continued

A Murabaha is defined by Fuqaha (jurists) as the sale of goods

at cost plus an agreed profit mark up .Its characteristic is that

the seller should inform the purchaser of the price at which

he purchased the product and stipulate an amount of profit

in addition to this.

We can redefine Murabaha as a sale in which the Islamic bank

informs the customer of its own cost and the profit it is taking

on the transaction and where the sale price is paid in

instalments over an agreed period of time.

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Shariah Principles & Rules in Murabaha

& MTPO

In a Murabaha to the purchase orderer, the promise of the

orderer to buy the goods from the orderer may be binding

or non-binding.

One group of Scholars view that the promise is non-bindingbecause:

The bank cannot sell what it does not possess (at the time of making

the promise)

The goods may be defective, deficient or unnecessary when delivered.

However, this will present problems to the Islamic banks as it

incurs cost to purchase the goods and as a financing

institution would not want to be left with unsold inventory.

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Continued

In order to reduce the risk of the Islamic bank, the bank mayrequire a depositfrom the Orderer (potential customer) to

ensure his seriousness.

Under the Sharia, there are two types of deposits which the

bank can demand: Hamish Jiddiyyah(Refundable): It is the amount paid by the purchase orderer

upon request of the purchaser to make sure that the orderer is serious in his

order of the asset. However, if the promise is binding and the purchase

orderer declines to purchase the asset, the actual loss incurred to the

purchaser shall be made good from this amount.

Urboun(Non-Refundable): It is the amount paid by the client (orderer) to the

seller (i.e., the original purchaser) when the former purchases an asset from

the seller. If the customer proceeds with the sale and takes the asset, then the

urboun will be part of the price; otherwise, the urboun will be forfeited by

the seller.

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Continued

In the case of late paymentand procrastination by thecustomer, the bank normally cannot levy any penalty as thiswould amount to interest.

If the sharia board agrees on a penalty, then this penaltycannot be recognized as revenue but given away as charity.

The Islamic bank can institute legal proceedings to recover thedebt and financial damage caused by procrastination (e.g. legalfees, lost opportunity).

If the indebted owner is insolvent and fails to settle the debt,

the bank should defer collection until he becomes solvent. Due to competitive pressures, the Islamic banks may give a

discount for early settlement. This is allowed under the Sharia

and is called Ibra.11


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12

Order Purchase

Financing

Deposit DisbursementReceivable /

collateral Cash / cash

equivalent

Gain/Loss on

disposal/deposit

refund

Refusal

Early

payment/defaultInstallment

repayment

Rebate/Write

-off

Transaction flow and accounting event:


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No. Transactions /Events DR CR.

1 Purchase of Asset byBank

Equipment Cash/Creditors

2 Murabaha saleMurabaha Financing (cost +profit) Equipment at cost and

Deferred profit or unearned income

with profit3 Installment receipt Cash Murabaha Financing

4Recognition of profit as

each installments

received

Deferred profit Profit and Loss

5. Termination of contract A/c Receivable Murabaha Financing6 Rebate for early paymentDeferred Profit Murabaha Financing

In Murabaha, be careful to deduct the security deposit either Hamish Jiddiyah or Urboun fromthe cost of the equipment or house before calculating the mark up. The mark up is on the

financinggiven to the customer, not the on cost of the equipment being financed.


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14

EG:

1. Dentist requires financing for dental chair costing RM100,000

2. Bank finances using Murabaha with deferred payment over 5 years.

3. Profit mark-up 10% = RM10,000

Accounting:1. Bank purchases dental chair

2. Bank structures murabaha financing

3. Customer pays first instalment

Need:1. Structure of the financing

2. Annual repayment amount

3. Deferred revenue amount

Cost + profit = RM110,000

= RM110,000/5 years = RM22,000

= profit component = RM10,000

Dr Murabaha equipment RM100,000

Cr Bank RM100,000

Dr Murabaha financing RM110,000

Cr Murabaha equipment RM100,000

Cr Unearned income RM 10,000

Dr Bank RM22,000

Cr Murabaha financing RM22,000

4. Revenue recognitionDr Unearned Revenue RM2,000

Cr Revenue Earned RM22,000


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15

Financial statement disclosure (components):

Murabaha financing (gross) RM88,000Unearned revenue RM8,000

Murabaha financing (net) RM80,000

Notes to account (see BISB)

2012 note 5 and note 21

Balance Sheet

15

Accounting:1. Bank purchases dental chair

2. Bank structures murabaha financing

3. Customer pays first instalment

Dr Murabaha equipment RM100,000

Cr Bank RM100,000

Dr Murabaha financing RM110,000

Cr Murabaha equipment RM100,000

Cr Unearned income RM 10,000

Dr Bank RM22,000

Cr Murabaha financing RM22,000

4. Revenue recognitionDr Unearned Revenue RM2,000

Cr Revenue Earned RM22,000


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16

financing 100,000.00

profit 20,000.00

period 5 years

1 2 3 4 5 IRR

(100,000.00) 22,000.00 22,000.00 22,000.00 22,000.00 22,000.00 3.2635% 110,000.03

PV @ IRR 21,304.72 20,631.42 19,979.39 19,347.97 18,736.50 100,000.00

interest 695.28 1,368.58 2,020.61 2,652.03 3,263.50 10,000.00

islamic conventional islamic conventional

principal at risk

1 100,000.00 100,000.00 2,000.00 3,263.50 3,263.502 80,000.00 81,263.50 2,000.00 2,652.03 2,652.03

3 60,000.00 61,915.53 2,000.00 2,020.61 2,020.61

4 40,000.00 41,936.14 2,000.00 1,368.58 1,368.58

5 20,000.00 21,304.72 2,000.00 695.28 695.28

10,000.00 10,000.00

Balance Sheet Profit & Loss

Analysis

Up to this point, Islamic

accounting understatesconventional and thereafter,

it overstates.

Reason: discounting effect

Islamic accounting understates asset in the balance sheet


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Measurement of Murabaha Financing

Assets & Income Recognition

Upon acquisition of Assets:

With obligation : Assets should be measured at lower of

historical cost or impaired value. (applying the prudence

concept of accounting & protect the purchaser)

Without Obligation: Assets should be measured at cash

equivalent value.(reflect current value & protect the bank/

financier)

A provision should reflect any decline between the acquisition

cost and cash equivalent value.

Price discount if obtained after acquisition should not be

treated as revenue but to reduce the cost of the relevant

goods unless agreed by SSB.17


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Continued

Upon financing the customer:

Murabaha receivablesshould be recorded (by the bank) at

face value (cash equivalent value) less provision for doubtful

debts.

Income recognition of Murabaha financing assets:

Profits are recognized at time of contracting for cash or credit

transaction not exceeding the current financial period.

If credit period > one financial period with a single or several

installment , the recognition methods are:

Accrual basis method

Cash basis method (????)

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Continued

Accrual basis method recognizes profit based on a

proportionate allocation of profits whether cash is received or

otherwise

Cash basis method recognizes profit as and when the

installments are received and requires the approval of SSB

Principle of matching expenses with income is applied

Deferral profits (unearned) shall be offset against Murabaha

receivables in the statement of financial position.

Settlement amount is based on outstanding financial amount

(accrual basis)

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Problem Illustration (BBA Financing)

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Bank Syariah Berhad provides a financing facility based on Bai Bithaman Ajil(BBA)principles to Ahmad bin Ali for the purpose of house purchase. The financing is

amounting to RM300,000 at a constant rate of return 8% for a period of 5 years. At the

end of the contract, Ahmad owes the bank a balance amounting to RM32,000. As part

of the normal requirements, the customers will be charged a penalty fee of 3% of the

outstanding amount due at the end of the contract and the amount collected is

normally disbursed as charity. The Bank recognizes income as instalments become dueand evenly over the period of the contract.

You are required to :

1. Prepare an extract of the balance sheet and income statement of Bank Syariah

Berhad from the beginning till the end of the contract to show the amount of netreceivable and Murabaha (BBA) income.

2. Prepare journal entries to record all the above transactions in the book of Bank

Syariah Berhad (including the treatment for penalty fee).


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Solution (Extract of Balance Sheet)

21

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5BBA

Financing420,000 336,000

(420 - 84)252,000

(336-84)168,000 84,000 0

Unearned

Income120,000 96,000

(120- 24 )72,000

(96-24)48,000 24,000 0

300,000 240,000 180,000 120,000 60,000 0

Working: Sale price = 300,000+markup[ (8%x5x300,000)120,000]=420,000Income earned Year 1 Year 5 = (120,000/5) 24,000 per yearInstallment payable per year =420,000/5=84,000 per year

1.


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Solution (Journal Entries)

22

2.

Year 0 Dr. BBA Fin 420,000

Cr. Cash 300,000

Cr. Unearned Income 120,000

( Recognition of BBA fin. )

Year 1 Dr. Cash 84,000

Cr. BBA Fin 84,000

( Repayment by customer )

Dr. Unearned income 24,000Cr. Profit and loss 24,000

(Recognition of income )

Note : The same transactions for year 2year 4


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Continued

23

Year 5 Dr. Accounts Receivable 32,000

Dr. Cash 52,000

Cr. BBA Fin 84,000

Dr. Unearned income 24,000

Cr. Profit and loss 24,000( Recognition of income )

Dr. Account Receivable 960

(Penalty BBA)

Cr. Charity payable 960

Note: when outstanding balance is received:

Dr. Cash 32,960

Cr. Account Receivable 32,960

Dr. Charity Payable 960

Cr. Cash (paid to charity) 960

Profit is recognized even

though loan remains

outstanding - Provided thisis not a bad loan

Amount outstanding

deemed paid and

transferred to normal

receivable.


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financing amount 300,000

rate (constant) 8.0%

period 5 years

amount owing 32,000 at end of 5 years

penalty at end of c 3.0%

A. calculate asset cost B. calculate profit, receivable & instalment

cost 300,000 300,000

profit 120,000

total value of asset 300,000 420,000

instalment 84,000

annual profit 24,000

C. instalment and accounting entries

BBA financing

BBA Asset bank receivable revenue unearned rev

purchase of house 300,000 (300,000)

BBA contract (300,000) 420,000 (120,000)

Start of ye ar i nstalment by cust

year 1 84,000 84,000 (84,000) (24,000) 24,000

year 2 84,000 84,000 (84,000) (24,000) 24,000

year 3 84,000 84,000 (84,000) (24,000) 24,000

year 4 84,000 84,000 (84,000) (24,000) 24,000

year 5 84,000 84,000 (84,000) (24,000) 24,000420,000 420,000 (420,000) (120,000) 120,000

net movement - 120,000 - (120,000) -

D. outstanding balance and penaltyamount outst 32,000 52,000

penalty 5% 960 goes to charity

total to be receive 32,960

repayment by customer

1 Dr BBA Asset 300,000

Cr Bank 300,000

(purchase of BBA Asset)

2 Dr BBA Receivable 420,000

CR unearned revenue 120,000Cr BBA Asset 300,000

(record receivable under BBA contract with 8% return)

3 Dr bank 84,000

cr BBA Receivable 84,000

(instalment received)

4 Dr unearned revenue 24,000

Cr BBA revenue 24,000

(annual profit recognition)

5 Dr bank 52,000

Dr Receivable 32,000

Cr BBA Receivable 84,000

(instalment partially received and termination of BBA contract)

6 Dr receivable 960

Cr charity payable 960


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25

1 Dr BBA Asset 300,000

Cr Bank 300,000

(purchase of BBA Asset)

2 Dr BBA Receivable 420,000

CR unearned revenue 120,000

Cr BBA Asset 300,000

(record receivable under BBA contract with 8% return)

3 Dr bank 84,000

cr BBA Receivable 84,000

(instalment received)

4 Dr unearned revenue 24,000

Cr BBA revenue 24,000

(annual profit recognition)

5 Dr bank 52,000

Dr Receivable 32,000

Cr BBA Receivable 84,000

(instalment partially received and termination of BBA contract)

6 Dr receivable 960

Cr charity payable 960

At time of

contract

Year 1 to year

5

Year 5


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0 1 2 3 4 5

PV factor 1.08 1.1664 1.259712 1.36048896 1.469328077

annual repayment amount RM75,136.94

repayment amount 375,685 75,137 75,137 75,137 75,137 75,137PV of repayment 300,000 69,571 64,418 59,646 55,228 51,137

interest component 75,685 5,566 10,719 15,491 19,909 24,000

PV of balance of payments 230,429 166,011 106,365 51,137 0

principal repaid

interest 75,685 24,000 19,909 15,491 10,719 5,566

principal 300,000 51,137 55,228 59,646 64,418 69,571

balance of principal 248,863 193,635 133,989 69,571 0

i

iAPV

n)1(

11

year1stfor300,000*8%

Principal*iinterest

Conventional accounting

at drawdown Dr loans receivable 300000

Cr Cash 300000

(Being loans drawdown)

1st payment Dr Cash 75,137

Cr loans receivable 51,137

Cr interest income 24,000

2nd payment Dr Cash 75,137

Cr loans receivable 55,228

Cr interest income 19,909

P&L

Islamic RM120K (8% on RM300K) simple ROR

Conventional RM75,685 (reducing balance)

Balance Sheet

Islamic RM420K recognition upfront

Conventional RM300K at PV (total repayment RM420,000 Vs RM375,685)

Effective yield

Islamic = 12.38% (equivalent to IRR); or

Conventional simple interest = 15137/300K=5.05%

Murabaha contract

We use the 8% return as the discount rate to find the

annual repayment of $75,136


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How do we calculate the repayment under the discounting

model?1. PV = $300,000; i= 8%, n = 5 years.

2. Using the i in (1) above, find the 5- yearly repayment of the

PV of $300,000.

i

iAPV

n)1(

11

08.

)08.1(

11

000,300)1(

11

000,3005

Xi

i n

(1.08)^5 1.469328077

1/(1.08)^5 0.680583197

1-[1/(1.08)^5] 0.319416803

{1-[1/(1.08)^5]}/.08 3.992710037

A 75,137

3. Split interest and principal components

from monthly repayment of $75,137

Year 1 principal repayment = $75,136-

$24,000 = $51,136

Yr 1 interest = $300,000 * 8% = $24,000

Yr 2 interest = $300,000 - $51,136) * 8% = $19,909

And so on ..

Note: this is for comparative purpose only. It is for those who are interested.

It is not intended that this is part of the core learning for this module.

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