Accounting for Murabahah Financing

 Murabahah financing is an asset based financing widely used for house and motor vehicle financing by Islamic banks. It is the most widely used financing instrument as it somehow resembles a loan contract.  Bay’ Al-Murabahah ( بيع المرابحة ) is basically an arrangement where the customers, who wishes to purchase certain goods or assets, requests the bank to purchase the items and sell them to him at cost plus a declared profit.  The Islamic bank determine the cost price of the commodity that it bought, and sells it at a declared profit.  In simple terms, Murabahah is sale of goods at cost plus mark up where the purchaser should be informed of the cost of goods or assets and the profit amount.

 The Murabaha conditions include the following: A. The Islamic bank should make the cost or capital outlay known to the client. B. The first contract should be valid. C. The contract should be free of usury. D. The Islamic bank should disclose any fault which occurs after the purchase and should disclose all what is related to the fault. E. The Islamic bank should disclose the terms applicable to the purchase price, for example if the purchase was on credit. F. If any of the conditions in (a), (d) or (e) is not met, the purchaser shall have the option to: 1. proceed with the sale as it is; 2. have recourse to the seller for the discrepancy; or 3. cancel the contract.  It is worth noting that a Murabaha sale in the above context means the selling of a product owned by the seller at the time of negotiation and contracting. (FAS 2, appendix B)

 The simple Murabahah is as follows:

Murabahah to the Purchase Orderer is where it involves three parties, namely, the purchase orderer, the purchaser and the seller. It involves intermediary due to lack of expertise or need for credit facility.

1. The customer orders the bank to purchase goods, which it promises (this may be binding or non binding) to buy from the bank giving it some profit. 2. The bank buys and pays for the goods from the vendor. 3. The banks executes a murabaha contract of sale to the customer and delivers the goods. 4. The customer pays for the goods on an installment basis to the bank.

 In a murabaha to the purchase orderer, the promise to buy of the customer (the purchase orderer) may be binding or non binding. This result from different shari’a opinions. One group of scholars view that the promise is non-binding because: 1. The bank cannot sell what it does not possess (at the time of making the promise) 2. 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.

 In order to reduce the risk of the Islamic bank, the bank may require a deposit from the orderer (potential customer) to ensure his seriousness. Under the shari’a, there are two types of deposits which the bank can demand:- 1. Hamish jiddiyyah 2. Urboun

 These two deposits are defined by FAS2 as follows:-  Hamish jiddiyyah  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  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 the seller.

 Hamish Jiddiyayah is problematic, because, in case of a non- binding promise, the bank will have to return the deposit in full to the potential customer, even if it subsequently incurs a loss in selling the goods, which the original orderer had refused to take delivery. In case, the promise is binding and the customer declines, the bank can deduct any losses and expenses it incurs on transaction from the deposit and return the excess. If the loss is greater than the deposit, the customer becomes liable for the balance.  In case of urboun deposit, this is deducted from the purchase price if the customer proceeds with the sale. If not, the customer looses his deposit, even if the deposit is more than the loss incurred by the bank

 In order to make it safer for Islamic banks, it should make the contract a binding promise and then require Hamish Jiddiyah or Urboun.  However, this does not solve the problem of credit risk i.e. payment default by customer. To mitigate this, the bank may request for a guarantee from the customer. The goods sold under murabaha can be a collateral for the debt. In this case, however, the customer cannot sell the goods until the debt is repaid to the bank.

 In the case of late payment and procrastination by the customer, the bank normally cannot levy any penalty as this would amount to interest. If the shari’a board agree on a penalty, then this penalty cannot be recognized as revenue but given away as charity.  The Islamic bank can institute legal proceedings to recover the debt and financial damage caused by procrastination (e.g. legal fees, “lost opportunity”).  Unless the goods sold are collateral, the goods cannot be taken by the Islamic bank to settle outstanding debt.

 If the indebted owner is insolvent and fails to settle the debt, the bank should defer collection until he becomes solvent.  If the bank gets a discount on the purchase price, this will belong to the bank unless it was obtained at the time of making the promise to buy (by the customer) or before the Murabaha sale was concluded.  The last rule to consider is early settlement of the debt or a lump sum payment before scheduled time. Since, the transaction is a sale, the bank is under no obligation to give a discount to the customer. However, due to competitive pressures, the Islamic banks do give a discount for early settlement. This is allowed under the shari’a and is called ‘ibra. The amount must be agreed between the bank and the customer at the time of settlement or before the lump sum payment is made.

 Another related model of Murabahah financing.  It is basically a trade-deal in which the seller allows the buyer to pay the price of a commodity at a future date in lump sump or installments.  Bay’ al muajjal refers to a sale against deferred payment (either in lump sump or instalments).  If the sale is to be paid by instalments then the specific term used is bai’ bithaman ajil.  Bay’ al-muajjal need not have a reference to the profit margin that the supplier may earn. Its essential element which distinguishes it from a normal sale is the deferred payment.

 In general, the sale (bai’) of any permissible thing is permissible, provided that there is consent by both parties.  Majority of the Muslim jurists allow the selling price in deferred sale to be set higher than the cash sale provided the object of the sale must come into the possession of the bank before being handed over to the other party.

 In addition, in case of default or delay of the payment by the customer, the price can no longer be raised. If the customer is in financial difficulty, more time should be given to him, and another date be fixed for the payment of the balance of the price.

 In order to be accepted in shari’ah, bai’ al-Murabahah should ensure the following matters: 1. The Islamic bank must actually hold and own the property before selling it to the customer 2. The first sale and purchase transaction between the bank and the producer of the commodity being a separate transaction altogether from the second sale and purchase transaction between the bank and the customer.

3. The Islamic bank should give the option to the customer whether to buy or refuse the goods upon seeing them, thus, it cannot enforce a binding promissory purchase contract on the customer. 4. The Islamic bank should bear the risk in the trade, i.e. by being responsible for the goods prior to its sale and actual delivery to the customer. 5. The Islamic bank should not take deposits in advance from the customer because such deposits signify the obligation to buy the goods and they also mean that the actual transaction takes place before the bank buys the goods;

6. The cost price must be known by the purchaser at the time of the contract (majlis al-‘aqad); 7. The profit over the cost price must be specified and known by both parties; 8. The cost price must be something that is quantifiable and substitutable; 9. The Murabahah must not involve any of ribawi items, payable by the same, which, may result in the occurrence of riba in the excess amount over the cost price. For instance, selling a kilogram of wheat for a kilogram of wheat also, plus a profit, which turns this case to be a clear riba al fadl; 10. The vendor must have bought the item for the bay’ al Murabahah in a valid sale and purchase contract.

 AAOIFI FAS 2 provides that ownership of the purchased asset is transferred to the buyer at the time of contracting. Thus, accounting journal entries to recognize the asset (financing) and income (profit) are as follows:  At the time of contracting (Recognition of BBA Financing asset): Dr. Murabahah / BBA Financing Account (with the Cost + Profit ) Cr. Cash Account or Account Payable (with the Cost) Cr. Unearned Financing Income Account (with the profit (mark-up))  When the installment is received: Dr. Cash Account Cr. Murabahah / BBA Financing Account (with the installment received )

 When the installment is due but not yet received: Dr. Receivable Account Cr. Murabahah / BBA Financing Account (with the instalment due)  When income is due to be recognized (accrual basis): Dr. Unearned Financing Income Account Cr. Profit and Loss Account (with the Murabahah / BBA Income due)  Note: Unearned income account is created to gradually and equally recognise income throughout the contract period. Unearned income account represents the total mark-up or profit to be received.

 AAOIFI FAS 2 considered two alternatives on this issue: 1. The first alternative was to measure the asset available for deferred payment sale at their purchase price. 2. The other alternative was to measure those assets at their acquisition cost, which is the purchase price plus any direct expenses associated with the acquisition process.  AAOIFI preferred the second alternative, which capitalizes direct expenses associated with the acquisition process.

 AAOIFI FAS 2 also considered two alternatives in the valuation of assets available for deferred payment sale at the end of the financial period: 1. The first alternative was to value the assets at their fair value. 2. The other alternative was to value the assets at their book value.  AAOIFI preferred the first alternative because these assets are treated as investments rather than fixed assets. Accordingly, their measurement at fair value should enable the institution to recognize and measure any unrealized gains and losses arising from the investment. This is in line with the alternative measurement attribute to the cash equivalent value concept.

 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 1. Prepare an extract of the Balance Sheet and income statement at the beginning and end of Year Prepare journal entries to record all the above transactions in the book of Bank.

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

Dr. Cr. Commodity a/c 200,000 Cash/Creditor a/c 200,000 (Purchase of Commodity) Murabaha Receivable 300,000 Commodity at cost 200,000 Deferred Murabaha Profit 100,000 At time of Murabaha Sales Cash 60,000 Murabaha Receivable 60,000 Recognition of profit on each installment‘s received Deferred Murabaha Income 20,000 Profit and Loss 20,000

 Bank Shari’ah provides a financing facility based on Murabahah to the Purchase Orderer principles to Ahmad Ali for the purpose of house purchase.  The financing is amounting to N300,000 at a constant rate of return 8% for a period of 5 years.  At the end of the contract, Ahmad owes the bank amounting to N32,000.  As part of the normal requirements, the customers will be charged a penalty fee of 3% per annum for any outstanding amount due at the end of the contract and the amount collected is normally disbursed as charity.

 You are required to: i. Prepare an extract of the balance sheet and income statement of Bank Shari’ah from the beginning till the end of the contract to show the amount of net receivable and Murabahah income. ii. Prepare journal entries to record all the above transactions in the book of Bank Shari’ah (including the treatment for penalty fee). iii. Explain the shari’ah requirements on the policy of charging penalty fee for default in repayment by customers. iv. Explain the similarities and the differences between Murabahah to the Purchase Orderer, and Bai’ Bithaman Ajil financing.

Year 0Year 1Year 2Year 3Year 4Year 5 BBA (420,000-84,000)(336,000-84,000)(252,000-84,000) Financing 420,000336,000252,000168,00084,0000 (120,000-24,000)(96,000-24,000) (72,000-24,000) Unearned Income 120,00096,00072,00048,00024,000 0 Net Balance 300,000240,000180,000120,00060,0000 (1) 8% X 5 = 40% (2) 300,000 X 140% = N420,000 (3) 120,000/5 = N24,000 (4) 420,000/5 = N84,000

Year 0 Dr. Cr. Dr. Murabahah Financing Account 420,000 Cr. Cash account 300,000 Cr. Unearned Income 120,000 (Recognition of Murabahah Financing)

Year 1 to Year 4 Dr. Cr. Dr. Cash Account 84,000 Cr. Murabahah Financing Account 84,000 (Being repayment by customers) Dr. Unearned Income Account 24,000 Cr. Profit and Loss Account 24,000 (Being recognition of income)

Year 5 Dr. Cr. Dr. Account Receivable 32,000 Dr. Cash account (84,000-32,000) 52,000 Cr. Murabahah Financing Account 84,000 Dr. Unearned Income Account 24,000 Cr. Profit and Loss Account 24,000 (Being recognition of income)

…..Year 5 Penalty = 3% x 32,000 x 1 / 12 = 80/month Dr. Cr. Dr. Account Receivable 960 Cr. Penalty (BBA) Account 960 (Being penalty charged) Dr. Cash Account 960 Cr Account Receivable 960 (Being penalty paid by customer)

( iii) Shari’ah requirements on penalty charges: A. Can be imposed only minimum amount e.g. only 1% per annum on payment in arrears and cannot be compounded. B. Maximum amount of penalty or ta’widh cannot exceed total amount of the remainder’s balance. C. Penalty obtained by the Bank or the financier may be earned and distributed according to normal profit distribution policy or distributed as charity.