Accounting for Islamic Banks and Financial Institutions Chapter 2 Accounting for Islamic Deposits and Investment Accounts Part 1

Differences between Conventional and Islamic banking

Difference between Conventional and Islamic banking

Difference between Conventional and Islamic banking

Difference between Conventional and Islamic banking

2012 figure includes : Islamic financial assets with Islamic banks, conventional banks' Islamic operations (windows and branches) Islamic financial assets with investment banks and investment companies (e.g., mudaraba companies in Pakistan). Islamic financial assets with islamic funds, and takaful companies (fully-fledged or Islamic operations of conventional insurance companies). This figure also includes the amount of sukuk outstanding at the end of 2012.

Deposits and investments Deposits and investments from depositors and investors are the main sources of funds especially for Islamic commercial banks. The deposits and investments collected from the surplus unit i.e. depositors and investors are used for financing to economic deficit unit i.e. customers etc. This is to ensure the proper functioning of a bank, including an Islamic bank, as a financial intermediary.

Accounting for Islamic Deposits and Investment Accounts In the case of Islamic banks there are a number of deposits and investment facilities created using Islamic contractual arrangements. Among the categories of Islamic bank deposits are as follows: Current Account (Al-Wadi’ah) Deposits Savings Account (Al-Wadi’ah) Deposits Investment Account (Unrestricted Mudharabah) Investment Account (Restricted Mudharabah)

(Al-Wadi’ah) Current Account Deposits and Savings Account Deposits Islamic financial institution structure their saving deposit account based on sharia principle, either in form of qard, wadiah yad damanah or mudarabah saving deposit. In all instances, no interest is paid, unlike the case in conventional banks. When the bank makes profit, it sometime gives Hadiah (gift) to current account and savings account holders entirely at its discretion - but increasingly - because of competition with conventional banks.

Principles of Wadi’ah Deposit and Accounting Implications Al-Wadi’ah is one of the most commonly used principles in the Islamic banks. It is used for the acceptance of deposits in the saving and current accounts. Al-Wadi’ah literally means “the thing left with a person who is not its real owner for the purpose of safe-keeping”. Al wadi’ah is considered to be a form of contract.

Principles of Wadi’ah Deposit and Accounting Implications The jurists of all schools of Islamic law (mazahib) agree that wadi’ah is a form of trust. Hence, the depositee i.e. the Islamic bank is regarded as the trustee to safely keep the deposited property in his custody. It follows that the depositee must return the deposited property to the depositor at any time upon the request of the latter. For both current and savings accounts, the depositors grant permission to the Islamic bank to mobilize the funds but at the same time guarantee their deposits (wadi’ah yadhamanah). No return is promised or expected but a gift (hibah) can be given to the depositors. In terms of accounting, no interest expense is recorded but the deposits will be treated as liabilities as they are guaranteed custody account.

The accounting recognition process The accounting recognition process (journal entries) are as follows: Dr. Cash Account Cr. Wadi’ah Deposit Account (with deposit received from depositor) Dr. Wadi’ah Deposit Account Cr. Cash Account with deposit repaid to depositor Dr. Profit and Loss account or Reserve Account with hibah disbursed to depositor

Investment Accounts Since there are no fixed deposit accounts (which is interest paying) in Islamic banks, they have investment accounts based on Mudharabah, a unique labour-capital partnership, which was the cornerstone alternative to interest based banking, advocated by early Islamic economists. Mudharabah contract is used both on the asset and liability side of the balance sheet. In the asset side, the bank is the rabbul mal providing financing while the customer is the mudharib. However , the mudharaba contract is used more widely on the liability or deposit sides. The bank is the mudahrib and the depositor is the rabbul mal.

Principles of Mudharabah Investment Account Al-Mudharabah is a form of partnership whereby the owner of capital, rab al- mal, gives a specified amount of capital to another person, termed as the mudharib. In this case, the Islamic bank, who is to act as the entrepreneur to trade with the capital. The profit will be shared between the two parties according to agreed profit sharing ratio of their agreement.

Principles of Mudharabah Investment Account On the other hand, if there is a loss then the loss will be borne by the rab al- mal who is the financier, whilst the mudharib only suffers the fruitless effort. However, if the loss is due to the willful negligence of the mudharib then he/she must be responsible for the loss. The liability of the rab al-mal in a Mudharabah is limited to the extent of his contribution to the capital.

Principles of Mudharabah Investment Account In Islamic banking, the bank may act as either the rab al-mal or the mudharib. In accepting deposits from its customers to be invested in fruitful business, the bank acts as a mudharib and the customers the rab al- mal. In financing the entrepreneurs or business projects, the bank acts as the rab al-mal and the entrepreneurs become the mudharibs. In this case, the bank is not participating in the management of the business financed. It could, however, exercise adequate supervision to ensure that the funds are being used in accordance with the Mudharabah agreement.

Principles of Mudharabah Investment Account The two-tier Mudharabah The Islamic bank may act as both the rab al-mal and the mudharib. This is what is termed as the two-tier Mudharabah. In this type of arrangement, it involves two separate contracts of Mudharabah; between the bank and the suppliers of capital (depositors) on the one hand, and between the bank and the users of capital (entrepreneurs) on the other. It is called two-tier Mudharabah because, one tier represents the Mudharabah between the bank and the suppliers of capital, and the other tier represents the Mudharabah between the bank and the users of capital. This is not a problem under the shari’a provided the two contracts are not linked and the depositor does not prohibit the bank from re-mudaraba.

financing models of mudaraba Mudharabah is a partnership, in which one or more parties (Rab ul Mal or sahibul mal) who provide the capital , contract with another party (the mudharib) who provide the labor, management expertise or entrepreneurship. This can take several forms Bilateral mudaraba Multilateral mudaraba Re mudaraba

financing models of mudaraba Bilateral mudaraba , where there is one capital provider and one entrepreneur (can be an organization such as an Islamic bank).

financing models of mudaraba Bilateral mudaraba If Rabbul Mal (RM) invested $200, 000 with Mudarib (MU) in the profit sharing ratio of 70:30 (70% to RM and 30% to MU), then if the investment results in a profit of $80,000, then the mudarib will get 30% i.e. $24,000 (30%x $80,000) and the Rab al Mal will get $56,000 (70% x $80,000). However, if the investment resulted in a loss of $80,000 instead, then all this loss of $80,000 will be borne by the rab al mal will , unless the mudarib was negligent.

financing models of mudaraba Multilateral mudaraba, where there are at least two capital providers and one entrepreneur

financing models of mudaraba Multilateral mudaraba, In the chart below, two rabs al mal invest $100,000 each with mudarib (MU) who invests it. The profit sharing agreement between the rabs al almal and the mudarbib being 70:30. If the ventures returns a profit of $80,000, then the mudarib gets (30%x$80,000), $24,000 and the rabs al mal share $56,000. This amount is allotted between RM1 and RM2 in proportion to their capital investment i.e 1:1 in this case, therefore they each get $28,000 If the loss is $40,000, then RM1 bears $20,000 and RM2 bears $20,000. The mudarib looses his labour, if the mudarib has NOT been negligent.

financing models of mudaraba Re mudaraba where, the entrepreneur sources and hires another mudarib under a another mudaraba contract. This is the

financing models of mudaraba Re mudaraba Rabbul Mal (RM) provides $100,000 capital to Mudarib (MU1) with PSR 70:30. This is in turn handed over to Mudarib 2 (MU2 )with profit sharing ratio 60:40. If the venture earns a profit of $50,000, then MU2 gets 40% of $50,000= $20,000, M1 gets30%x60%x$50,000= $9,000 and the rab al mal gets 70%x60%x$50,000= $21,000. However, if the investment results in a loss of $30,000, this loss is borne by the rab al mal.