Islamic Financial Accounting Standard-1 Murabaha Interpretation and Implementation Effective date January 1, 2006 Ahmed Ali Siddiqui Vice President & Manager Product Development & Shariah Compliance Meezan Bank Limited

Scope of Presentation The scope of this presentation comprises of two main parts; - Basic Concepts, Modalities and Documentation of Murabaha Transaction - Process Flow of Murabaha Transaction - Documentation - Accounting Policies and Recording Procedure involved in Murabaha transaction as per the requirements and guidelines of IFAS-1 - Accounting Policies - Recording procedure and disclosure of Murabaha transaction as per IFAS-1

Introduction Murabaha is a kind of Sale whereby “Cost” as well as the “Profit” is known to the Buyer and the Seller. Payment of Murabaha price may be: 1) At spot In installments In lump sum after a certain time Hence, Murabaha does not necessarily imply the concept of deferred payment.

Process Flow Murabaha Financing 1. Client and the Bank sign an agreement to enter into Murabaha through a Master Murabaha Financing Agreement (MMFA). Agreement to Murabaha Bank Client

Process Flow Murabaha Financing 2. Client appointed as an agent to purchase goods on the Bank’s behalf. Agreement to Murabaha Bank Client Agency Agreement

Process Flow Murabaha Financing 3. Bank gives money to an agent/supplier for purchase of goods. Disbursement to the agent or supplier Agency Agreement Supplier Agreement to Murabaha Bank Client

Process Flow Murabaha Financing 4. The agent takes possession of goods on the Bank’s behalf. Transfer of Risk Delivery of goods Vendor Bank Agent

Process Flow Murabaha Financing 5(a). Client makes an offer to purchase the goods from the Bank through a declaration. Offer to purchase Bank Client

Process Flow Murabaha Financing 5(b). Bank accepts the offer and sale is concluded / culminated. Murabaha Agreement + Transfer of Title Bank Client

Process Flow Murabaha Financing 6. Client pays agreed price to the Bank according to an agreed schedule. Usually on a deferred payment basis (Bai Muajjal) Payment of Price Bank Client

Stages in Murabaha Financing There are two stages in Murabaha transaction: Investment Stage (Agency to Purchase) Financing Stage (Declaration to payment) Profit Recognition in Murabaha The profit for the Murabaha transaction shall be recognized after the goods are sold by the bank to the customer.

Murabaha Documentation There are a number of documents involved in a Murabaha financing transaction. The most essential of these documents are: 1) Master Murabaha Financing Agreement (MMFA) Agency Agreement 3) Draw Down Notice Summary Payment Schedule Declaration Details of Assets

Murabaha Documentation 1) Master Murabaha Agreement Its an agreement between the client and the Bank whereby the client agrees to purchase goods from the Bank from time to time as per the terms and conditions of this Agreement. This is an over all facility agreement under which various Sub-Murabahas may be executed from time to time.

Murabaha Documentation 2) Agency Agreement The client is appointed by the Bank as its agent to purchase goods. This agreement needs to be signed once between the client and the bank. The disbursement of funds is done under this Agreement. List of assets form part of the main Agency Agreement which defines the assets that the client is authorised to by on behalf of the bank acting as an agent. 3) Draw Down Notice These documents are required for each disbursement/Murabaha tranche. Draw down notice must mention the amount.

Murabaha Documentation 4) Summary Payment Schedule Summary of Payment schedule should be finalized prior to signing of declaration of Murabaha agreement. 5) Declaration (Offer & Acceptance document) Declaration is to be signed by the customer immediately after the purchase of the goods by the customer. This document establishes the actual sale transaction, i.e. transfer of ownership of goods from the Bank to the customer. At this stage the specific details of the assets must be known i.e. quantity, quality, price etc. Proper timing of declaration is extremely important.

Murabaha Documentation 6) List of Assets This forms part of the declaration whereby details of the goods purchased are disclosed. Purchase evidences to be attached with the details of assets as a proof of purchased by the client as an agent of the Bank. The purchase evidences may includes the invoices, good receiving notes, good delivery challans or any other suitable evidence, preferably in the name of the Bank or in the name of the client as an agent of the Bank.

Accounting Policy for Murabaha IFAS 1 - Murabaha

Transaction Recording Accounting Policy for Murabaha Transaction Recording Funds disbursed for purchase of goods are recorded as ‘Advance for Murabaha’. On culmination of Murabaha i.e. sale of goods to customers, Murabaha financings are recorded at the deferred sale price net of profit. Previously, Murabaha financings were recorded at the time of disbursement of funds. Goods Purchased but remaining unsold at the balances sheet date are recorded as inventories. Previously these were recorded as Advance against Future Murabaha. Financing are stated net of specific and general Provisions against non- performing financings, if any, which are charged to the profit and loss account.

Revenue Recognition Accounting Policy for Murabaha Profit on Murabaha Financings is recognised on accrual basis. Effective January 01, 2006, profit on Murabaha transactions for the period from the date of disbursement to the date of culmination of Murabaha is recognised immediately upon the later date. Previously, profit on Murabaha was recognised from the date of disbursement.

Reason for Change in accounting Policy Below is a brief summary of recording procedure of the Bank for Murabaha transactions both post and pre adoption of “IFAS-1 Murabaha”. Pre-adoption 1) Murabaha Financings were recorded at the time of disbursement of funds. 2) Goods purchased but remaining unsold at the balance sheet date were recorded as ‘Advance against future Murabaha’. 3) Profit for the Murabaha transaction was recorded from the date of disbursement. Post-adoption 1) Funds disbursed for purchase of goods are recorded as ‘Advance for Murabaha’. On culmination of murabaha i.e. sale of goods to customers, Murabaha Financings are recorded at the deferred sale price net of profit payment. 2) Goods Purchased but remaining unsold at the balances sheet date are recorded as Inventories. 3) Profit for the period from the date of disbursement to the date of culmination of murabaha is recognized immediately after the date of culmination of Murabaha..

Case Study for Murabaha Below is the case study for the understanding of Murabaha transactions carried out at Meezan Bank in various scenarios: Example Amount in Rs./% Purchase price/Cost/Principal 1,000 Profit Rate 10% Tenure One year Total profit on transaction 100 Sale price (Contract price) 1,100 Date of Disbursement to supplier/customer January 01,2007 Date of Culmination of Murabaha Transaction January 15,2007 Date of Maturity of Murabaha December 31, 2007

Dr Advance against Murabaha (B/S Asset side) 1,000 Scenario-A A-When there is bullet payment of profit and Cost (Principal) at the end of the period: 1) At the time of payment to the client for the purchase of goods on behalf of bank or directly to the supplier by the bank the transaction will be accounted for as follows: January 01, 2007 Dr Advance against Murabaha (B/S Asset side) 1,000 Cr Pay Order / Party Account (B/S Liability side) 1,000

Dr Unearned Murabaha Profit Receivable 100 Scenario-A 2) At the Culmination of Murabaha i.e. at the time of sale of goods to the customers with signing of Declaration by the bank and the client following entries would be passed: January 15, 2007 Dr Murabaha Financing 1,000 Dr Unearned Murabaha Profit Receivable 100 Cr Advance against Murabaha 1,000 Cr Deferred Murabaha Income 100 3) Booking of Accrual of profit@ 10% from the date of disbursement to the date of culmination, the following entry would be passed. [(1000 x 10%) x 15 / 365]: Dr Deferred Murabaha Income 4.10 Dr Murabaha Profit Receivable 4.10 Cr Income on Murabaha Financing 4.10 Cr Unearned Murabaha Profit Receivable 4.10

Scenario-A-continued 4) Booking of Accrual of profit@ 10% for remaining days of the month, the following entry would be passed. [(1000 x 10%) x 16 / 365]: January 31, 2007 Dr Deferred Murabaha Income 4.39 Dr Murabaha Profit Receivable 4.39 Cr Income on Murabaha Financing 4.39 Cr Unearned Murabaha Profit Receivable 4.39 And so on this entry will be passed at the end of EACH month till maturity for the accrual of profit. Disclosure in Balance Sheet as on January 31, 2007 Murabaha receivable-gross 1,100 Less: Deferred Murabaha Income {100- (1000x10%x31/365)} (91.51) Murabaha Profit Receivable shown in other assets (8.49) Murabaha Financing Receivable 1,000

Scenario-A-continued 5) On Maturity of Murabaha transaction i.e. on December 31, 2007 and at the time of receiving of final payment following entry would be passed: December 31, 2007 Dr Party Bank A/c 1,100 Cr Murabaha Financing 1,000 Cr Murabaha Profit Receivable 100

Dr Advance against Murabaha 1,000 Cr Pay Order / Party Account 1,000 Scenario-B B-In case Declaration is not received on January 15, 2007 and is received on February 15, 2006: 1) At the time of payment to the client for the purchase of goods on behalf of bank or directly to the supplier by the bank the transaction will be accounted for as follows: January 01, 2007 Dr Advance against Murabaha 1,000 Cr Pay Order / Party Account 1,000 On January15, 2007 No entry would be passed At the end of First Month i.e. January 31, 2007 No entry would be passed for accruals of profit, as Declaration has not been received from the customer.

Dr Unearned Murabaha Profit Receivable 100 Scenario-B 2) On February 15, 2007, at the culmination of Murabaha i.e. at the time of sale of goods to the customers with signing of Declaration by the bank and the client, the following entries would be passed: February 15, 2007 Dr Murabaha Financing 1,000 Dr Unearned Murabaha Profit Receivable 100 Cr Advance against Murabaha 1,000 Cr Deferred Murabaha Income 100

Scenario-B-continued 3) Booking of Accrual of profit@ 10% from the date of disbursement to the date of culmination, the following entry would be passed. [(1000 x 10%) x (31+15)/ 365]: February 15, 2007 Dr Deferred Murabaha Income 12.60 Dr Murabaha Profit Receivable 12.60 Cr Income on Murabaha Financing 12.60 Cr Unearned Murabaha Profit Receivable 12.60

Scenario-B-continued 4) Booking of Accrual of profit@ 10% for remaining days of the month, the following entry would be passed. [(1000 x 10%) x 13 / 365]: February 28, 2007 Dr Deferred Murabaha Income 3.56 Dr Murabaha Profit Receivable 3.56 Cr Income on Murabaha Financing 3.56 Cr Unearned Murabaha Profit Receivable 3.56 And so on this entry will be passed at the end of EACH month till maturity for the accrual of profit. NOTE: In case the Murabaha declaration is NOT received on the due date, NO Entry would be passed until the declaration is received. Disclosure in Balance Sheet as at February 28, 2007 Murabaha receivable-gross 1,100 Less: Deferred Murabaha Income{100- (1000x10%x(31+28)/365)} (83.84) Murabaha Profit Receivable shown in other assets (16.16) Murabaha Financing Receivable 1,000

Scenario-B-continued 5) On Maturity of Murabaha transaction i.e. on December 31, 2007 and at the time of receiving of final payment following entry would be passed: December 31, 2007 Dr Party Bank A/c 1,100 Cr Murabaha Financing 1,000 Cr Murabaha Profit Receivable 100

Treatment for Inventory If goods purchased for Murabaha remain unsold on the reporting date they are shown as “Murabaha Inventory” in Other Assets. Following are possible scenario: Bank is holding assets for future sale to its customers against a promise The Goods are imported as Bank’s agent and are not sold to the importers i.e. they are in PAD Any other reason due to which the goods remain unsold.

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