Accounting for Islamic Banks and Financial Institutions Chapter 3 Accounting for Mudharabah Financing

3.2 Accounting for Mudharabah Financing  Mudharabah is a concept where the capital provider or the Islamic bank (rab al-mal) and the small entrepreneur (mudharib) become a partner.  The profits from the project are shared between capital provider and entrepreneur, but the financial loss will be borne entirely by the capital provider. This is due to the premise that a mudharib invests the Mudharabah capital on a trust basis; hence it is not liable.  for losses except in cases of misconduct. Negligence and breach of the terms of Mudharabah contract, the mudharib becomes liable for the amount of capital.

3.2 Accounting for Mudharabah Financing  There are three fundamentals for Mudharabah financing, namely: 1. The two contracting parties, i.e. rab al-mal (capital provider) and mudharib (entrepreneur) 2. The subject matter of the Mudharabah, i.e. capital, labour and profit; and 3. The offer and acceptance.

3.2 Accounting for Mudharabah Financing  The conditions of Mudharabah pertain to three of the fundamental elements of Mudharabah, i.e. the two contracting parties, the capital and the profit.  Profit : the amount received that exceeds the capital  Profit Sharing Ratio should be determined at the time of contracting and profit to be shared should be known  Can be limited to a period.

3.2 Accounting for Mudharabah Financing  With regards to the conditions for the two contracting parties, i.e. rab ul- mal and mudharib, both of them must have the capacity to enter into a contract of agency (Wakalah). This is because, the authorisation by the rab ul- mal or sahibul mal to the mudharib is considered to be a form of agency, whereby, the rab ul-mal is the principal and the mudharib is the agent.

3.2 Accounting for Mudharabah Financing  Islam is not a condition for both contracting parties.  No work interference by capital provider  The entrepreneur should comply with Shari’ah rules  The entrepreneur should comply with capital provider’s instructions  No guarantee of recovery of fund.  Capital (can be trade & non-monetary assets)  No debt to be treated as capital  Manner of disbursement (lump sum or in several installments).

Forms of Mudarabah Transactions Bilateral Mudarabah (Simple Mudarabah) One party of capital provider and another party of entrepreneur Re-Mudarabah (Two tier Mudarabah) : Three parties and includes capital provider intermediate Mudarib (entrepreneur) and final mudarib (entrepreneur) Multilateral Mudarabah: Several parties of capital provider and one party of entrepreneur If there is one party of capital provider and several parties of entrepreneurs will it be still considered as multilateral mudarabah? 7

Illustration of Bilateral Mudarabah C1 provides RM100,000 to E1 and PSR is 70:30 If profit is RM40,000 C1 recovers RM100,000 - capital and shares RM28,000- profit E1 shares RM12000 profit If Loss is RM 20,000 C1 bears the loss of RM20,000, and recover RM80,000 capital 8

Illustration of Multilateral Mudarabah C1 provides RM50,000 C2 provides RM50,000 PSR is 70:30, If profit is RM 40,000 C1 recovers RM50,000 capital and shares RM14,000 profit C2 recovers RM50,000 capital and shares RM14,000 profit E2 shares RM12,000 profit If loss is RM20,000 C1 bears the loss of RM10,000 and recover RM40,000 capital C2 bears the loss of RM10,000 and recover RM40,000 capital 9

Illustration of Re-Mudarabah CI provides RM100,000 PSR between C1 and E1 (intermediary) is 70:30 PSR between E1(intermediary) and E2 is 60:40 If profit is RM40,000 E2 shares profit of RM16,000 (40,000 x 0.4) E1 shares profit of RM 7,200 (40,000x 0.6x 0.3) C1shares RM16,800 (40,000 x 0.6x0.7) If loss is RM 20,000 C1 bears the loss of RM20,000 and recover RM80,000 capital 10

 FAS 3, Mudaraba Financing is a standard for the provision of mudaraba financing by the Islamic bank and does not deal with the deposit side of receiving the funds on mudaraba basis. However, in this chapter we will consider both.  When the capital is paid to the mudarib or placed in his disposition (for example, credited to his account) then Mudaraba financing capital is recognized by debiting Mudaraba Financing and crediting cash.  If the capital is paid in installments, each installment is recognized as capital when paid. Recognition and Measurement of Mudaraba Financing

 If payment of capital is conditional of an occurrence of a future event or delayed to a future time, capital is recognized only when it is paid to the mudarib.  If the capital is in the form of non-monetary assets such a plane or building then the heading of “non Monetary mudaraba asset. Recognition and Measurement of Mudaraba Financing

 If capital provided by the Islamic bank is in kind (trading assets or non-monetary assets), the capital shall be valued at fair value of the assets. Any difference between fair value and book value shall be recognized as profit or loss to the bank.  Expenses of contracting procedures such as feasibility studies are not considered mudaraba capital unless specifically agreed. Recognition and Measurement of Mudaraba Financing

Accounting issues on Mudarabah  Bahrain Islamic Bank executes a mudaraba contract for $1,000,000 with Babul Bahrain constructions on 1 Muharram The feasibility study and legal expenses cost the bank $50,000 and was paid by the Bank. The $1,000,000 is to given to babul Bahrain constructions for their use in the mudaraba as follows:  1 Muharram 1428: $200,000 cash +$300,000 (fair value) of a crane which was used for ijarah purposes by the bank in a previous assets with a book value of $400,000.  1 Safar 1428: $200,000 fair value of construction materials which was left over from terminated istisna contract, the carrying value was $150,000.  1 Jamada I, : $300,000 in cash.  Required: Journal entries in the books of Bahrain Islamic Bank for the above transactions which were executed as scheduled. ILLUSTRATION RECOGNITION OF MUDARABA FINANCING

One-period Mudharaba  Example 2  Islamic Bank signed a mudharaba contract for $300,000 with Al nahda company on January, The $ $300,000 is to given to Al nahda in cash at the date of contract.  The profit ratio sharing (PRS) is between the Bank (Rabb al-Mal) and Al nahda (Mudarib) respectively  The bank received the following payments from Al nahda company as follows:  Jan.15 :100,000  Feb. 15:70,000  Mar. 5:100,000  Mar. 15:80,000 and the parties agreed to end the Mudaraba successfully  Required: Journal entries in the books of Islamic Bank for the above transactions. ILLUSTRATION RECOGNITION OF MUDARABA FINANCING

Solution: Jan.1 : Dr. Mudharabah Financing 300,000 Cr. Cash 300,000 Jan.15 : Dr. Cash100,000 Cr. Mudharabah Financing 100,000 Feb. 15 : Dr. Cash70,000 Cr. Mudharabah Financing 70,000 Mar. 5 : Dr. Cash100,000 Cr. Mudharabah Financing 100,000 Mar. 15 : Dr. Cash80,000 Cr. Mudharabah Financing 80,000

Solution: Mudharabah profits = Received payments - Mudharabah Financing = = The bank share = 60% x = The Mudareb share = 40% x = Mar. 15 Dr. Mudharabah Financing 50,000 Cr. Investment profits & losses30000 Cr. Current accounts (Al nahda company ) 20000

 Example 3  Data for Al nahda company Mudharabah Financing, are presented in Example 1, suppose that the payments received amounted to and 1. There is no evidence about negligence from Mudarib Mudharabah losses = Received payments - Mudharabah Financing = = (30000) The bank share = The Mudareb share = 0 Mar. 15 Dr. Investment profits & losses/ Mudharabah 30,000 Cr. Mudharabah Financing The losses resulted from negligence of Mudarib The bank share = 0 The Mudareb share = Mar. 15 Dr. Mudaraba Recievables (Al nahda company ) 30,000 Cr. Mudharabah Financing 30000

Some Legal Principles of Mudarabah Transactions (continued) Profit Recognition 1. Realisation Method: according to Hanbali and Shafie is when the revenue is earned i.e. after determining its costs 2. Distribution Method: according to Maliki it is realised upon distribution between the two parties 20

Measurement of Mudaraba Capital at the end of the financial year after contracting.  Mudaraba capital should not be revalued subsequent to the execution of contract.  Any repayment of capital should be deducted from the Mudaraba Financing Account.  If a partial loss of the capital occurs (e.g. theft or fire) before the work on the mudaraba is started (and this is NOT caused by negligence of the mudarib.), this should also be deducted from mudaraba financing account and debited to pofit and loss account.  If the whole of the mudarba capital is lost, (not due to mudrib) then the Islamic bank must bear the loss, and terminate the mudarba contract.  Any unpaid amounts remaining becomes a receivable of the bank from the ex mudarib.

Recognition of the Islamic bank’s share in the profit and losses  If a mudaraba starts and finishes within the financial year of the bank, profit and losses (bank’s share) should be recognized by the bank in that financial year.  If a mudraba transaction carries on after the financial year end, the profit or losses should be recognized in the accounts for that period. To the extent that profits are distributed. The Islamic Bank’s share of losses should be recognized to the extent such losses are deducted from the Mudaraba capital.  If the mudraba is terminated or settlement is made and the mudarib has not paid the profits to the bank, this will be treated as a receivable from the mudarib.

Recognition of the Islamic bank’s share in the profit and losses  Losses due to liquidation is recognized at the time of liquidation by reducing the Mudaraba capital.  ANY MISCONDUCT OR NEGLIGENCE OF THE MUDARIB RESULTING IN LOSSES WILL BE BORNE BY THE MUDARIB AND IT BECOMES A RECEIVABLE DUE FROM THE MUDARBIB.

Non Monetary MudarabaH capital  Is discouraged by fuqaha  Valued at fair value, any difference between fair value and book value goes to the profit and loss  Any provision made for the decline in the value of Mudaraba assets should be DISCLOSED in the notes to the accounts.

AAOIFI : Presentation and Disclosure of Mudarabah Financing Balance Sheet Mudaraba Financing ( Non Monetary Mudarabah Asset)* XX Less : Provision for decline in value of Mudarabah Assets (XX) Net Mudarabah FinancingXX *Jointly or self financed assets Income statement Mudarabah incomeXX 25

Accounting Problem  Bank Syari’ah Malaysia Berhad contributed $2,000,000 for a four-year Mudaraba financing contract (Mudarabah Muqayaddah) at the profit sharing ratio of 2:1 between the Bank (Rabb al-Mal) and Ihsan Corporation (Mudarib) respectively.  Assume that the venture incurred a loss of $150,000 in the first year; realized profit of $375,000 in the second year; incurred a loss of 250,000 in the third year; and realized profit of $350,000 in the fourth year. Required: A. Prepare the necessary journal entries to recognize asset and profit/loss of the above transactions, and show how profit/loss will be allocated between the Bank, and the Mend of first, second, third and fourth year, if the profit of Mudarabah is determined at the end of: I. each period II. at the end of the contract B. Comment on the impacts different basis of profit allocation (i.e. each period vs. end of the contract) on the income of the Bank and the Mudarib. C. What are the different forms and types of Mudarabah contracts?

Solution: Each period method : Year 0: Dr. Mudharabah Financing 2,000,000 Cr. Cash 2,000,000 Year 1: Dr.Profit and Loss 150,000 Cr. Mudharabah Financing 150,000 ( loss in 1st year ) Year 2 : Dr. Cash / Receivable (2/3 x 375,000) 250,000 Cr. Profit and Loss 250,000 (Profit in 2nd year )

Solution: Each period method : Year 3 : Dr. Profit and Loss 250,000 Cr..Mudharabah Financing 250,000 ( loss in 3rd year ) Year 4 : Dr. Cash / Receivable (2/3 x 375,000) 233,333 Cr. Profit and Loss 233,333 (profit in 4th year ) Dr. Cash / Receivable 1,600,000 Cr. Mudharabah Financing 1,600,000 ( Capital repayment, year 4 )

Solution: End of contract Method: End of contract Method: Year 1: Dr. Mudharabah Financing 2,000,000 Cr. Cash 2,000,000 Year 4 : Dr. Cash / Receivable 2,000,000 Cr. Mudharabah Financing 2,000,000

Solution: End of contract Method: Profit / Loss 1. Year 1 ( 150,000) 2. Year 2 375, Year 3 ( 250,000) 4. Year 4 350,000 Year 4 : Dr. Cash / Receivable 216,667 Cr. Profit and Loss 216,667

Comparison between the different methods:

 Different method (end of contract vs. Each period) will lead to different amount of income recognized by both the Rabbul-Mal and Entrepreneur.  For each period, loss during the contract will borne by Rabbul Mal, thus reduced total profit. Mudharib only earned profit not loss (protect Mudharib) may lead to moral hazard.  For end of contract,loss will be absorbed by profit, some argued not true Murbahah, some others argued that we should consider it as a project basis.  Method of profit recognition must be transparent to both parties at the beginning of the contract to avoid abuse by one party over the other.