ACCOUNTING FOR ISLAMIC EQUITY FINANCING

mudarabah

Nature of Mudarabah Financing Mudarabah is a contract in which one party provides capital ( Rabbul mal/ capital provider) and the other party provides work (Mudarib / entrepreneur) Profits : Shared between the parties according to a predetermined profit sharing ratio Losses : To be borne by the capital providers- Violation of the stipulated contract by the entrepreneur , the entrepreneur bears such loss Is the capital provider a sleeping partner?

Some Legal Principles of Mudarabah Transactions 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 Capital provider bears the loss unless due to trespass or omission Offer and Acceptance Capital (can be trade & non- monetary assets) No debt to be treated as capital Manner of disbursement (lump sum or in several installments)

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 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 except for betrayal guarantee (performance bond)

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?

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

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

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

Accounting issues on Mudarabah Recognition of Asset and Liability Recognition of Profit/ Income or Loss/ Expense Valuation of Asset Disclosure

Recognition of Mudarabah Financing - ( Asset) Dr Mudarabah Financing Cr Cash (Being provided Mudarabah financing to Mudarib) Dr Cash Cr Mudarabah Financing (Being repayment or Mudarabah repaid by Mudarib) Cr P&L (Being received profit from Mudarib) Dr P&L (Being set off Mudarabah loss borne by Rabbul Mal)

Recognition and Measurement of Mudarabah Financing FAS 3, Mudarabah Financing is a standard for the provision of Mudarabah financing by the Islamic banks and does not deal with the deposit side of receiving the funds on Mudarabah basis

Measurement of Mudarabah capital at the end of the financial year after contracting Measured at initial carry value except for repayment of capital which should be deducted from the Mudarabah financing. However if the partial loss of the capital occurs (eg. theft and fire) before the work on the Mudarabah is started (and not due to negligence of the Mudarib), this should also be deducted from Mudarabah financing account and debit to P & L If the whole of Mudarabah capital is lost, Rabbul Mal must bear the loss and terminate the contract Any unpaid amounts remaining becomes a receivable of the bank from ex-mudarib.

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

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 Financing *Jointly or self financed assets Income statement Mudarabah income

example Bank Syari’ah Berhad contributed RM1,000,000 for a four-year Mudaraba financing at the profit sharing ratio of 70:30 between the Bank and Ihsan Corporation (Mudarib) respectively. Assume that the venture incurred a loss of RM150,000 in the first year; realised a profit of RM50,000 in the second year; incurred a loss of RM250,000 in the third year; and realised a profit of RM350,000 in the fourth year. Required: a. Calculate the profit/loss earned/incurred by the bank for the Year 1 to Year 4 b. Prepare the necessary journal entries for Year 1 and Year 2

MUSHARAKAH

Nature of MusharakaH Financing A partnership between the Islamic bank and its clients, where both parties: Contribute equal or varying amounts of capital to establish a new project or share in an existing one; Capital can be on permanent or declining (capital) basis and will have his due share of profits; and, Partners share proportionate losses according to the capital contribution and not other wise.

MusharakaH Principles Competent contracting parties The capital shall be in cash, gold or silver or equivalent; realty (goods, real estates machines); or intangible rights (e.g. patents) or equivalents The partner does not guarantee another partner’s capital or funds except in case of negligence or omission. Any exchange or sale of capital to the other partner should not be at historical cost but at the fair value at the time of sale. Profits can vary with the agreement and capital contribution and to be distributed upon completion. Loss to be shared according to capital contribution (credit guarantee) and can be carried forward or offset.

Journal entries Dr Musharakah Financing Cr Cash ( Being financing for customers / partners) Dr Cash Cr Musharakah Financing (Being repayment by customers/ partners) Cr P&L (Being profit received from Musharakah financing) (Being payment received for the purchase of banks share in a Diminishing Musharakah)

Types of MusharakaH Financing Constant Musharakah: the partner’s share in Musharakah capital remains (constant) throughout its period Musharakah Diminishing to Ownership: one party has the right to purchase a part of the other party’s share which declines until one becomes the sole proprietor of all capital (Musharakah Mutanaqisah)

Illustration of Diminishing MusharakaH B Constant CCR or PSR?

Accounting Treatment of MusharakaH Financing Recognition & Measurement Upon receipt or deposited in a Musharakah Account known as “Musharakah Financing”. Constant Musharakah capital: the capital at the end of period is measured based on historical cost. Diminishing Musharakah capital: measured at historical cost after excluding the sold portion (fair value) is the basis of measurement. Any difference between fair value and historical cost is the bank’s profit or loss Upon termination: Outstanding capital becomes receivable.

Presentation and Disclosure of MusharakaH Financing Balance Sheet Musharakah Financing * XX Less : Provision for loss in Musharakah Financing (XX) Net Musharakah Financing XX * Jointly or Self FinancedAssets Income Statement Musharakah Income XX

EXAMPLE Ali entered into a Mudarabah agreement with Bank Muamalat who agreed to provide RM300,000 financing. Profit sharing between Ali and the bank in ratio of 4:6 respectively. Profits and losses for the first two years of the agreement were as follows: Year 1: Loss RM100,000 Year 2: Profit RM50,000 It was agreed to convert the Mudarabah to a Musharakah with Ali putting in RM100,000 as capital. The new profit sharing ratio was Ali 60% and Bank 40%. The results of the Musharakah venture was as follows: Year 3: Profit RM150,000, Year 4: Profit RM100,000, Year 5: Loss RM50,000. The bank decided to terminate the agreement at the end of year 5. It was agreed that RM20,000 of the loss was due to negligence of Ali. Required: Prepare journal entries for Year 1 to Year 5.