WORKSHOP ON ACCOUNTING OF MURABAHA UNDER IFAS – 1 Presentation By: Omar Mustafa Ansari Partner – Islamic Financial Services Ford Rhodes Sidat Hyder & Co.

OUTLINE What is Murabaha? Difference of treatment Acquisition of asset Valuation of Inventory Discounts Sale to the purchase orderer Profit Recognition Early settlement Treatment of Security Deposit Loss in absence of Guarantee Customer’s Default SBP’s Shariah Essentials Accounting for Liability Side Presentation By: Omar Mustafa Ansari – Partner – Ford Rhodes Sidat Hyder & Co.

What is Murabaha? Murabaha is a cost plus profit sale, i.e. a sale in which the seller informs the customer about his cost and the amount of profit. Contemporary Murabaha transaction (referred to as Murabaha to the Purchase Orderer by AAOIFI Standard) is normally a deferred payment sale. Ba’y Murabaha, by its very nature, is a purchase-sale / trading transaction. In other words it is not a “financing” transaction and instead, it is a substitute to financing transactions. Presentation By: Omar Mustafa Ansari – Partner – Ford Rhodes Sidat Hyder & Co.

Murabaha – Difference of Treatment Accordingly, the IFAS - 1 issued by ICAP, as well as, the AAOIFI standard consider it a trading transaction and suggest the accounting treatment like a trading transactions with certain exceptions. On the other hand, the conventional banks, as well as, Islamic banks operating in Pakistan were accounting for Murabaha as a financing transaction (just like an interest-bearing loan) and ignoring the purchase and sales of goods. Presentation By: Omar Mustafa Ansari – Partner – Ford Rhodes Sidat Hyder & Co.

Murabaha – Acquisition of Asset Payment made to supplier or agent for purchase of asset is accounted for as advance. Asset is initially measured and recorded at historical cost, including all costs necessary to bring the asset in its present location and condition. Perpetual or periodic method of accounting for inventories / purchases may be used. Presentation By: Omar Mustafa Ansari – Partner – Ford Rhodes Sidat Hyder & Co.

Murabaha – Valuation of Inventory IFAS requires that if inventory is lying with the Bank, the IAS applicable to inventories shall be applied. In case where the customer has not fulfilled his promise to purchase the inventory, the same needs to be brought down to Net Realizable Value (NRV). If he has not defaulted, then even the market value of goods is declined, since the Bank is sure that it is able to sell the inventory at a profit (Murabaha price) it would not be required to write down the inventories. Presentation By: Omar Mustafa Ansari – Partner – Ford Rhodes Sidat Hyder & Co.

Murabaha – Valuation of Inventory AAOIFI requires that if there is an indication of non-recovery of costs of goods, the asset shall be measured at cash equivalent value (Net realizable value) through a provision. Presentation By: Omar Mustafa Ansari – Partner – Ford Rhodes Sidat Hyder & Co.

Murabaha – Discounts According to AAOIFI standard, if a discount is received from the supplier, it shall not be considered as revenue and instead it should reduce the cost of goods. The discount may be treated as revenue if this is decided by the Islamic Bank’s Shari’a Supervisory Board. Presentation By: Omar Mustafa Ansari – Partner – Ford Rhodes Sidat Hyder & Co.

Murabaha – Sale to the Purchase Orderer It shall be recorded at the time of occurrence at invoiced amount i.e. gross selling price. Presentation By: Omar Mustafa Ansari – Partner – Ford Rhodes Sidat Hyder & Co.

Murabaha – Profit Recognition Profit shall be recognized at the time of consummation of sales, if the sale is for cash or on credit but the term does not exceed the current financial period. The profit on portion of Murabaha receivable not due for payment should be recorded as “Unearned Murabaha Income” with a corresponding liability on the balance sheet called “Deferred Murabaha Income”. Presentation By: Omar Mustafa Ansari – Partner – Ford Rhodes Sidat Hyder & Co.

Murabaha – Profit Recognition As per AAOIFI Standard, profits of credit sale whose payment due after the current financial period shall be recognized using any of the following methods: Preferred method – Proportionate allocation of profits whether or not cash is received; Allowed Alternative method – Profit may be recognized as and when the amount is received. Accrued amount of profit which is not yet received is disclosed. Deferred profits shall be offset against (shown as a deduction from) Murabaha receivables in the statement of financial position / balance sheet. Presentation By: Omar Mustafa Ansari – Partner – Ford Rhodes Sidat Hyder & Co.

Purchase of Assets and sale to purchase orderer Murabaha Receivable is recorded at Rs. 12 M including unearned Murabaha income and a liability of Rs. 2 M is recorded. Records asset at full amount of Purchase Price less discount BANK Rs. 10 M Rs. 12 M Asset Rs. 12 M Liability Rs. 2 M Any decline in value shall be reflected at the end of financial period Rs. 2 M recognized as income over a period of Murabaha term Presentation By: Omar Mustafa Ansari – Partner – Ford Rhodes Sidat Hyder & Co.

Murabaha – Early Settlement According to most of the jurists in Pakistan, no discount can be allowed in case of early settlement. Accordingly, in case of early settlement, deferred Murabaha income should be immediately recognized. However, IFAS – 1 is silent in this respect. Presentation By: Omar Mustafa Ansari – Partner – Ford Rhodes Sidat Hyder & Co.

Murabaha – Early Settlement According to AAOIFI Standard: Deduction of profit at the time of settlement The Bank may deduct the part of the profit agreed upon from payment of one or more installments. This is, however, not allowed by a number of jurists, particularly in Pakistan. Deduction of part of profit after settlement The above criteria should be applied for payments of one or more installments before the time specified, the Islamic Bank may ask the client to pay the full amount and thereafter reimburse with part of profit. Presentation By: Omar Mustafa Ansari – Partner – Ford Rhodes Sidat Hyder & Co.

Murabaha – Treatment of Security Deposit (Hamish Gedayyah) IFAS – 1 is silent regarding treatment of security deposit may be obtained from the Purchase Orderer at the time of initial promise to purchase. According to AAOIFI standard, such deposit shall be treated as liability on Islamic Bank. In case the customer does not fulfill his promise to purchase the asset: If the promise by the Purchase Orderer is a non-binding promise, the security deposit shall be returned in full even if the asset is sold at lower amount to another customer or in the market; If the promise is a binding promise, the amount of actual loss shall be deducted from the security deposit. Presentation By: Omar Mustafa Ansari – Partner – Ford Rhodes Sidat Hyder & Co.

Murabaha – Loss in absence of guarantee / security deposit In absence of any guarantee or security deposit, any loss incurred shall be recorded as receivable due from the defaulter client. Presentation By: Omar Mustafa Ansari – Partner – Ford Rhodes Sidat Hyder & Co.

Murabaha – Customer’s Default – Charity IFAS – 1, does not specifically mention about the accounting treatment for charity (in case of customer’s default). However, in basic Shariah principles and features of Murabaha, it mentions that self-imposed penalty for charitable purpose may be included to avoid defaults. However, such charity would not form income of the Bank and shall be utilized for charitable purposes only. Accordingly, any charity amount received should directly be recorded as a liability. Presentation By: Omar Mustafa Ansari – Partner – Ford Rhodes Sidat Hyder & Co.

Murabaha – Customer’s Default – Charity According to AAOIFI Standard: Procrastination The amount received as a penalty shall be treated as revenue or an allocation to charity fund as the Shari’a Board deems appropriate. Normally, in Pakistan, the jurists do not allow it as revenue and instead they say that it has to be directly paid by the customer in the charity fund. Insolvency The Islamic Bank cannot ask the client to pay any additional amount by way of penalty. Presentation By: Omar Mustafa Ansari – Partner – Ford Rhodes Sidat Hyder & Co.

SBP’s Shariah Essentials – For Murabaha Shariah Essentials for Murabaha, as issued by the SBP’s Shariah Board have been included as an appendix to IFAS – 1 and are deemed to be an integral part of the same. In addition, IFAS – 1, itself provides basic Shariah principles and features of Murabaha. There is a debate, as to whether these essentials, which otherwise are considered as “guidelines” become “standard” (legally applicable) by virtue of being part of this standard. Presentation By: Omar Mustafa Ansari – Partner – Ford Rhodes Sidat Hyder & Co.

Accounting for Liability Side IFAS – 1 deals with the accounting as the seller in a Murabaha transaction, which is generally the position of Islamic financial institutions. It does not deal with the accounting for the purchaser in a Murabaha transaction, either for the Islamic financial institutions or for their customers. Accordingly, there are a few Modarabas who have not applied this standard on their liability side Murabaha transactions. Presentation By: Omar Mustafa Ansari – Partner – Ford Rhodes Sidat Hyder & Co.

Accounting for Liability Side According to IAS – 2 and IAS – 16, the costs of inventories and items of property, plant and equipment (fixed assets) should not include the additional cost representing financial charges against deferred delivery. Accordingly, normally the purchasers in Murabaha transactions have to follow these standards and to record the differential as financial charges (except where these qualify as borrowing costs). Presentation By: Omar Mustafa Ansari – Partner – Ford Rhodes Sidat Hyder & Co.