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ACCOUNTING FOR MURABAHA

Omar Mustafa Ansari Partner Islamic Financial Services Group Ford Rhodes Sidat Hyder & Co. A member firm of Ernst & Young Global Limited

WHAT IS MURABAHA?

Murabaha is a cost plus profit sale, i.e. a sale in which the seller informs the customer about his cost and the amount of profit. Contemporary Murabaha transaction (referred to as Murabaha to the Purchase Orderer by AAOIFI Standard) is normally a deferred payment sale. Bay Murabaha, by its very nature, is a purchase-sale / trading transaction. In other words it is not a financing transaction but it is used as a substitute to financing transactions.

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MURABAHA DIFFERENCE OF TREATMENT

Accordingly, the IFAS - 1 issued by ICAP, as well as, the AAOIFI standard consider it a trading transaction and suggest the accounting treatment like a trading transactions with certain exceptions.
On the other hand, the conventional banks, as well as, Islamic banks operating in Pakistan were accounting for Murabaha as a financing transaction (just like an interest-bearing loan) and ignoring the purchase and sales of goods.

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IMPORTANT DEFINITIONS
Promise Promise is an obligation issued by one party (in Murabaha, the orderer or the purchaser). The promise is binding in religious law on the individual who makes it, unless an excuse arises and prevents its fulfillment. Nevertheless, a promise is binding from the juristic perspective if it is pending on a cause and the promise has incurred cost by reason of the promise.
Right of option Right of option is the right of the orderer or the contracting parties to proceed in the execution of the sale on the basis of mutual promising or to decline to do so when the purchaser has possession of the asset and offers it to the orderer.
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IMPORTANT DEFINITIONS
Hamish Jiddiyyah Hamish Jiddiyyah 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 from this amount.
Urboun Urboun 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 the seller.

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IMPORTANT DEFINITIONS
Procrastination by a solvent debtor Procrastination is the delay in fulfilling an obligation, and procrastination of the solvent debtor is the delay on the part of a solvent person and his evasion of paying the debt without having an excuse or being insolvent.
Insolvency Insolvency means inability of the debtor to settle the debts due from him because of an insufficiency or a total lack of funds. Face value The amount of a Murabaha receivable based on the price agreed between the client and the Islamic Bank including the latters profit on the transaction.
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IMPORTANT DEFINITIONS
Historical Cost The purchase price or the cost of acquisition of an asset plus any other expenses incurred by the Islamic Bank e.g., custom duties and other taxes on purchase, transport and loading charges, insurance and any other expenses directly related to the available goods.
Cash equivalent value The number of monetary units that would be realised if an asset was sold for cash in the normal course of business as of the current date.

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MURABAHA ACQUISITION OF ASSET

Payment made to supplier or agent for purchase of asset is accounted for as advance.
Asset is initially measured and recorded at historical cost, including all costs necessary to bring the asset in its present location and condition. Perpetual or periodic method of accounting for inventories / purchases may be used.

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MURABAHA VALUATION OF INVENTORY

IFAS requires that if inventory is lying with the Bank, the IAS applicable to inventories shall be applied. In case where the customer has not fulfilled his promise to purchase the inventory, the same needs to be brought down to Net Realizable Value (NRV). If he has not defaulted, then even the market value of goods is declined, since the Bank is sure that it is able to sell the inventory at a profit (Murabaha price), it would not be required to write down the inventories.

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MURABAHA VALUATION OF INVENTORY

AAOIFI Standard requires that if there is an indication of nonrecovery of cost of goods, the asset shall be measured at cash equivalent value (Net realizable value) through a provision.

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MURABAHA DISCOUNTS FROM SUPPLIERS

According to AAOIFI standard, if a discount is received from the supplier, it shall not be considered as revenue and instead it should reduce the cost of goods. The discount may be treated as revenue if this is decided by the Islamic Banks Shariah Supervisory Board.

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MURABAHA SALE TO THE PURCHASE ORDERER

It shall be recorded at the time of occurrence / consummation at invoiced amount i.e. gross selling price.

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MURABAHA PROFIT RECOGNITION

Profit shall be recognized at the time of consummation of sales, if the sale is for cash or on credit but the term does not exceed the current financial period. The profit on portion of Murabaha receivable not due for payment should be recorded as Unearned Murabaha Income with a corresponding liability on the balance sheet called Deferred Murabaha Income.

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MURABAHA PROFIT RECOGNITION

As per AAOIFI Standard, profits of credit sale whose payment due after the current financial period shall be recognized using any of the following methods: Preferred method Proportionate allocation of profits whether or not cash is received; Allowed Alternative method Profit may be recognized as and when the amount is received. Accrued amount of profit which is not yet received is disclosed.
Deferred profits shall be offset against (shown as a deduction from) Murabaha receivables in the statement of financial position / balance sheet.

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PURCHASE OF ASSETS AND SALE TO PURCHASE ORDERER

BANK

Rs. 10 M

Records asset at full amount of Purchase Price less discount

Rs. 12 M

Murabaha Receivable is recorded at Rs. 12 M including unearned Murabaha income and a liability of Rs. 2 M is recorded.

Any decline in value shall be reflected at the end of financial period

Asset Rs. 12 M Rs. 2 M recognized as income over a period of Murabaha term

Liability Rs. 2 M

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MURABAHA EARLY SETTLEMENT

According to most of the jurists in Pakistan, no discount can be allowed in case of early settlement. Accordingly, in case of early settlement, deferred Murabaha income should be immediately recognized. However, IFAS 1 is silent in this respect.

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MURABAHA EARLY SETTLEMENT

According to AAOIFI Standard:

Deduction of profit at the time of settlement : The Bank may deduct the part of the profit agreed upon from payment of one or more installments. This is, however, not allowed by a number of jurists, particularly in Pakistan. Deduction of part of profit after settlement : The above criteria should be applied for payments of one or more installments before the time specified, the Islamic Bank may ask the client to pay the full amount and thereafter reimburse with part of profit.

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MURABAHA TREATMENT OF SECURITY DEPOSIT (HAMISH JIDDIYYAH)

IFAS 1 is silent regarding treatment of security deposit may be obtained from the Purchase Orderer at the time of initial promise to purchase.

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MURABAHA TREATMENT OF SECURITY DEPOSIT (HAMISH JIDDIYYAH)

According to AAOIFI standard, such deposit shall be treated as liability on Islamic Bank. In case, the customer does not fulfill his promise to purchase the asset: If the promise by the Purchase Orderer is a non-binding promise, the security deposit shall be returned in full even if the asset is sold at lower amount to another customer or in the market; If the promise is a binding promise, the amount of actual loss shall be deducted from the security deposit.

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MURABAHA LOSS IN ABSENCE OF GUARANTEE / SECURITY DEPOSIT

In absence of any guarantee or security deposit, any loss incurred shall be recorded as receivable due from the defaulter client.

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MURABAHA CUSTOMERS DEFAULT CHARITY


IFAS 1, does not specifically mention about the accounting treatment for charity (in case of customers default). However, in basic Shariah principles and features of Murabaha, it is mentioned that self-imposed penalty for charitable purpose may be included to avoid defaults. However, such charity would not form income of the Bank and shall be utilized for charitable purposes only. Accordingly, any charity amount received should directly be recorded as a liability. Keeping in view the Instructions for Shariah Compliance for Islamic Banking Institutions, a separate fund is required to be maintained and the Statement of Sources and Uses of Charity Fund should be disclosed.
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MURABAHA CUSTOMERS DEFAULT CHARITY

According to AAOIFI Standard: Procrastination The amount received as a penalty shall be treated as revenue or an allocation to charity fund as the Shariah Board deems appropriate. Normally, in Pakistan, the jurists do not allow it as revenue and instead they say that it has to be directly paid by the customer in the charity fund.
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Insolvency The Islamic Bank cannot ask the client to pay any additional amount as a of penalty.

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SBPS SHARIAH ESSENTIALS FOR MURABAHA

Shariah Essentials for Murabaha, as issued by the SBPs Shariah Board have been included as an appendix to IFAS 1 and are deemed to be an integral part of the same. In addition, IFAS 1, itself provides basic Shariah principles and features of Murabaha.
There is a debate, as to whether these essentials, which otherwise are considered as guidelines become standard (legally applicable) by virtue of being part of this standard. This debate is now settled with issuance of Instructions for Shariah Compliance for Islamic Financial Institutions by the SBP.

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ACCOUNTING FOR LIABILITY SIDE


IFAS 1 deals with the accounting as the seller in a Murabaha transaction, which is generally the position of Islamic financial institutions. It does not deal with the accounting for the purchaser in a Murabaha transaction, either for the Islamic financial institutions or for their customers. Accordingly, there are a few Modarabas who have not applied this standard on their liability side Murabaha transactions.

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ACCOUNTING FOR LIABILITY SIDE


According to IAS 2 and IAS 16, the costs of inventories and items of property, plant and equipment (fixed assets) should not include the additional cost representing financial charges against deferred delivery.
The purchasers in Murabaha transactions have to follow these standards and to record the differential as financial charges (except where these qualify as borrowing costs).

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SAMPLE ACCOUNTING ENTRIES FOR MURABAHA UNDER IFAS-1


1 Advance paid to customer under Master Murabaha Facility Master Murabaha Facility Advance against Murabaha (B/S Asset Side) Asset Side) Customers current account / Cash / DD (B/S) DD (B/S) 2 Item purchased by the Bank or the customer on the customer on the Banks behalf Murabaha inventory (B/S Asset Side) / purchases (P/L) Side) / purchases (P/L) (in case of perpetual / periodic perpetual / periodic system) Supplier account / Cash / DD / Advance against 6-7 July 2009 Page against Murabaha Finance Advance26 Accounting for Islamic(B/S) By: Omar Mustafa Ansari Debit 100 Credit

100

100 100

SAMPLE ACCOUNTING ENTRIES FOR MURABAHA UNDER IFAS-1


3 Murabaha sales after purchase of items Murabaha receivables (gross amount) (B/S Asset Side) Murabaha Sales (P/L) 4 If inventory was recorded then this is the additional entry required (simultaneous) Murabaha cost of sales (P/L) Murabaha inventory (B/S Asset Side) 5 Profit deferment (simultaneous) Unearned Murabaha income (P/L) Deferred Murabaha income (B/S Liability Side)
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Debit 120

Credit 120

100 100

20 20

SAMPLE ACCOUNTING ENTRIES FOR MURABAHA UNDER IFAS-1


6 Profit recognition (each month end) Deferred Murabaha income (B/S Liability Side) Unearned Murabaha income (reversal) (P/L) 7 Settlement of Murabaha Receivable Cash (B/S Asset Side) 120 Debit 5 5 Credit

Murabaha receivables (gross amount) (B/S Asset Side)


8 Penalty received (Charity) Cash 1

120

Charity fund payable


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SAMPLE ACCOUNTING ENTRIES FOR MURABAHA UNDER IFAS-1


Debit 9 Charity Paid Charity fund payable Cash 1 1 Credit

Note:

Charity income and expenses are directly transferred to the charity fund instead of routing through the P&L.

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MURABAHA SAMPLE DISCLOSURE


Amount in Rupees
Murabaha sale price Purchase price Deferred Murabaha income Opening balance Deferred during the year Recognised during the year Murabaha receivable Opening balance Sales during the year Received during the year
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465 (400)

65
135 65 (95)

105
850 465 (730)

585

ILLUSTRATION

Illustration #1 ABC Islamic Bank provides a Murabaha of US$ 200,000/- for a Commodity at a constant rate of return of 10% for period of 5 Years and requires an annual installment payment of 60,000/Requirement Prepare an extract of the Balance Sheet and income statement at the beginning and end of Year 1.

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ILLUSTRATION AAOIFI STANDARD

Solution
Workings: Total Unearned income = (5 60,000) 200,000 = $ 100,000 Income per year $ 20,000
Balance sheet Murabaha receivable Unearned Murabaha income Net receivable Income statement Murabaha Income Year 0 (300,000) (100,000) 200,000 Year 1 (240,000) (80,000) 160,000

20,000

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ILLUSTRATION
Date Narration Amount in US$
Dr. 200,000 Cr. 200,000

Commodity a/c Cash/Creditor a/c (Purchase of Commodity)

Murabaha Receivable
Commodity at cost Deferred Murabaha Profit (At time of Murabaha Sales)
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300,000
200,000 100,000 100,000

ILLUSTRATION
Date Narration Amount in US$
Dr. 60,000 Cr.

Cash

Murabaha Receivable (Purchase of Commodity)


Recognition of profit on each installments received

60,000

Deferred Murabaha Income Profit and Loss


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20,000 20,000

ILLUSTRATION
Mr. Ahmed made a non binding promise to an Islamic Bank that he would buy a van from ABC Co. through a Murabaha transaction. Based on that promise, the Islamic Bank collected Hamish jiddiyyah of US$ 500 from him, and bought a van from a vendor for US$ 5,000. After the van is delivered to the Islamic Bank, Mr. Ahmed decided not to buy it. The Islamic Bank then sold the van to another customer, Mr. Bashir, for US$, 4,500 in cash. Which of the following should apply? The IB should return US$ 500 to Mr. Ahmed. The IB should return US$ 300 to Mr. Ahmed. The IB should not return any money to Mr. Ahmed.

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