How are profits recognized and earned?
When we talk about income recognition, we have to admit that Islamic banks do not have its own income recognition formula for debt financing facility. Except for Musharakah and perhaps Ijarah (considered as pure rental income) there is "no hadith" (perhaps Shariah scholars can help us on this issue) that distinguish the profit and principal portion meant for debt financing facility. Thus, Islamic bank today are actually adopting the conventional bank's formula for debt financing facility with strict modification that income cannot be earned on COMPOUNDED basis.
What do we meant by "on compounded basis?" My straight forward answer is that when recognising financing income, Islamic banks cannot adopt the "interest-upon-interest" method used by conventional banks. For example, when a conventional bank customer defaulted his installment this month, the unpaid interest amount will be added to the following month opening principal balance [ i.e. unpaid interest + principal outstanding = new month opening balance.] Thus, interest for the following month is calculated over the new opening principal balance.
For Islamic banks, unpaid profit shall remain as "profit earned but not yet paid" and that amount CANNOT become part of principal amount of the following month or the month after irrespective whether the customer defaulted or the account is to be restructured or rescheduled.
The Writer had earlier mentioned there is no 'hadith" specifying the formula and how income is to be earned thus, the Writer opines that banks' Shariah Committees are not worry about income "recognition formula" as long as the calculation method and the amount calculated are not deemed as ' interest ' when earned. Although there may be disagreement among the Shariah Scholars as to whether certain Islamic products or structures are shariah compliant, to-date, Shariah Scholars tend not to get involved in the "formula arithmetic" in determining the profits. One important Shariah requirement when it comes to income recognition is that earning MUST be based on NON-COMPOUNDING basis and should never emulate the conventional method where compounding or "interest-upon-interest" method has been in used since ages. Although from some information there are Islamic banks that earn "compounding income", we really hope that this is not the case. If you are an Islamic banker, why not do a quick check on how your bank earns their financing income for default cases?
When we talk about income recognition, we have to admit that Islamic banks do not have its own income recognition formula for debt financing facility. Except for Musharakah and perhaps Ijarah (considered as pure rental income) there is "no hadith" (perhaps Shariah scholars can help us on this issue) that distinguish the profit and principal portion meant for debt financing facility. Thus, Islamic bank today are actually adopting the conventional bank's formula for debt financing facility with strict modification that income cannot be earned on COMPOUNDED basis.
What do we meant by "on compounded basis?" My straight forward answer is that when recognising financing income, Islamic banks cannot adopt the "interest-upon-interest" method used by conventional banks. For example, when a conventional bank customer defaulted his installment this month, the unpaid interest amount will be added to the following month opening principal balance [ i.e. unpaid interest + principal outstanding = new month opening balance.] Thus, interest for the following month is calculated over the new opening principal balance.
For Islamic banks, unpaid profit shall remain as "profit earned but not yet paid" and that amount CANNOT become part of principal amount of the following month or the month after irrespective whether the customer defaulted or the account is to be restructured or rescheduled.
The Writer had earlier mentioned there is no 'hadith" specifying the formula and how income is to be earned thus, the Writer opines that banks' Shariah Committees are not worry about income "recognition formula" as long as the calculation method and the amount calculated are not deemed as ' interest ' when earned. Although there may be disagreement among the Shariah Scholars as to whether certain Islamic products or structures are shariah compliant, to-date, Shariah Scholars tend not to get involved in the "formula arithmetic" in determining the profits. One important Shariah requirement when it comes to income recognition is that earning MUST be based on NON-COMPOUNDING basis and should never emulate the conventional method where compounding or "interest-upon-interest" method has been in used since ages. Although from some information there are Islamic banks that earn "compounding income", we really hope that this is not the case. If you are an Islamic banker, why not do a quick check on how your bank earns their financing income for default cases?
Based on Writer's past banking experience, income for financing under lease, debt or profit sharing contract can be recognised using the undermentioned formulas :-
Note : Some of the formulas may no longer in use.
Note : Some of the formulas may no longer in use.
1. Payments to be treated as profit first (cash accounting)
Using straight line method as per example in Chart 1, for the first four (4) years whatever installments received are to be treated as profits/ income to the bank while the principal amount is payable over the remaining financing tenor.
Before we show you the various charts on the income recognition methods, lets understand the table columns showed in the chart 1:
a) Month - the month installment due and income earned;
b) Monthly Installment - can only calculate this if we know the (i) financing amount (ii) financing tenure or financing period and (iii) profit rate which can be based on monthly rest, flat rate, daily rest or yearly rest depending on the type of structure.
c) Amortisation - the distribution of profit to be earned by the bank and gradual payment of principal amount, embedded together in the monthly installment;
d) Unearned profit - total profits due (for whole facility) to the bank and payable by the customer. The longer the financing period, the higher will be the unearned income. Unearned income plus principal will equal to sale price for debt financing. For conventional banking there is no sale price but the same can be determined by calculating the installment amount times financing period in no. of months.
e) Original Principal - this equal to the original financing amount;
f) Balance Outstanding - comprise [ original principal + unearned income after net off the monthly installment.] Only when this figure is zerorised, the financing facility is considered paid in full. In debt financing facility, the balance outstanding is equal to the sale price outstanding amount.
Now let's look at Chart 1 again.
Before we show you the various charts on the income recognition methods, lets understand the table columns showed in the chart 1:
a) Month - the month installment due and income earned;
b) Monthly Installment - can only calculate this if we know the (i) financing amount (ii) financing tenure or financing period and (iii) profit rate which can be based on monthly rest, flat rate, daily rest or yearly rest depending on the type of structure.
c) Amortisation - the distribution of profit to be earned by the bank and gradual payment of principal amount, embedded together in the monthly installment;
d) Unearned profit - total profits due (for whole facility) to the bank and payable by the customer. The longer the financing period, the higher will be the unearned income. Unearned income plus principal will equal to sale price for debt financing. For conventional banking there is no sale price but the same can be determined by calculating the installment amount times financing period in no. of months.
e) Original Principal - this equal to the original financing amount;
f) Balance Outstanding - comprise [ original principal + unearned income after net off the monthly installment.] Only when this figure is zerorised, the financing facility is considered paid in full. In debt financing facility, the balance outstanding is equal to the sale price outstanding amount.
Now let's look at Chart 1 again.
Chart 1
Workings
# Unearned Income [ 10,000,000 x 8.25% x 10 years = 8,250,000 ]
# Installment [ 10,000,000 + 8,250,000 = 18,250,000 divide by 10 years = 1,825,000 ]
Is there a bank earning using the above formula? Yes..! but the Writer is not sure whether this bank still exits or still doing it. In 1996, the Writer attended an Islamic banking seminar in Istanbul, Turkey. One of the speakers in the said seminar reiterated that his family bank (Gulf based) earned income based on above method because it is privately owned bank (then) and does not depend on public deposits.
2. Amortize monthly using straight line method over deferred payment tenure# Unearned Income [ 10,000,000 x 8.25% x 10 years = 8,250,000 ]
# Installment [ 10,000,000 + 8,250,000 = 18,250,000 divide by 10 years = 1,825,000 ]
Is there a bank earning using the above formula? Yes..! but the Writer is not sure whether this bank still exits or still doing it. In 1996, the Writer attended an Islamic banking seminar in Istanbul, Turkey. One of the speakers in the said seminar reiterated that his family bank (Gulf based) earned income based on above method because it is privately owned bank (then) and does not depend on public deposits.
Under this method, amortization of profits and principal are divided equally over the payment periods (refer Chart 2) . In real situation, this type of formula is normally used for short term financing e.g. 3 to 6 months financing period.
Chart 2
Workings
# Unearned Income [ 6,000,000 x 8.25% x 0.5 months = 247,500]
# Principal payment [ 6,000,000/ 6 months = 1,000,000 ]
# Profits [247,500 / 6 months = 41,250 ]
# Installment [1,000,000 + 41,250 = 1,041,250 ]
Since the principal balance is on reducing balance, while income amount is the same throughout the financing tenure, effective yield (due to same income but lower principal balance) become higher as the facility is about to mature e.g. 25% on the 6th month.
3. Amortize monthly using similar amortization formula (a) Monthly Reducing Balance; or (b) Flat Profit Rate (Rule 78)
(a) Monthly Reducing Balance (MRB)
The most common earning formula used by existing Islamic banks is MRB formula (refer to Chart 3). Under this formula, income earning can be divided into two (2) types:-
(i) Pre-scheduled method - similar to calculation using Microsoft Office EXCEL programme. This formula is also known as Constant Rate of Return Formula.
and
(ii) Reducing Method - profits are calculated based on outstanding principal balance on month-to-month basis.
More detailed examples of the above will be discussed in our our later session on "Islamic Accounting"
Chart 3
For Excel table, you can use the following formula:
#Monthly Installment: = PMT(PR/100)/12, Tx12, - P where PR=Profit Rate, T=Tenure and P=Principal
# Sale Price = Monthly Installment x [ Tenure x 12 ]# Unearned Income = Sale Price - Principal
or use the formula as follows:
(b) Flat Rate
The flat rate profit method (also known as Rule 78) is used for hire purchase (Ijarah Thumma Al-Bai) and lease financing (Ijarah or Ijarah Muntahiya Bitamlik). Example of Rule 78 is as per Chart 4.
Chart 4
The formula:
4. Joint-Venture Profit Sharing Method
Profit is calculated based on agreed profit sharing ratio (PSR) pre-determined prior entering the joint-venture contract. Profit/(or losses, if any) is normally determined on completion of project/maturity of financing term. If profits are paid in advance (normally at certain agreed percentage), the advances amount will be re-calculated once actual profit/(or losses) has been determined. Example of profit sharing ratio table is as per Chart 5 below.
Chart 5
5. Yearly Rest Method
Yearly rest method is used by most banks sometime late 1980s or early 1990s. This formula was later discontinued when the BNM (through the Association of Banks Malaysia) issued a new regulation to standardize the formula calculation for term loans etc. Based on Chart 6 below, the profit/(or interest since this is commonly used by conventional banks) it re-calculated every January 1st based on the outstanding principal balance on 31 December each year.
Chart 6
Normally for yearly rest calculation, the amount outstanding may take slightly longer period to be paid due to the way the profit (or interest) is calculated and also depending on the prevailing interest/(profit). Based on simulation as per Chart 7 below, the financing/loan only full paid on 10.4 years.
Chart 7
6. Daily rest method
Daily rest method is normally used for Cash Line (or overdraft) financing facility. Daily rest calculation is similar to the monthly rest method but the only different here is that profit is calculated on daily basis based on daily principal balance. Unlike conventional banking, the daily profits cannot be compounded. At month-end whatever daily profit accrued will be totalled up as income for the month.
Thus, based on the above examples, there are six (6) profit calculation methods (maybe there's more) but most commonly used by Islamic banks today are method 3, 4 and 6.
In our next session, we shall discuss about profit distribution using the reducing balance method.
IslamicBankingWay.Com
ALLAH KNOWS BEST.
No comments:
Post a Comment