Monday, September 10, 2012

33B(ii) ACCOUNTING ENTRIES

If you are operating a full fledged Islamic bank, there should not be much issue on the accounting entries but if you are operating a "dual window operation" i.e. Islamic operation within the mother conventional bank, the full set of accounts must be separated. Attached chart is self-explanatory.

Chart 1 - Segregation of Account Reporting





To know whether certain products are truly shariah compliant, always zoom to the accounting entries. Based on my consulting experience and industry information, there are banks (both Islamic and window operations) that failed to see the importance of accounting entries in an Islamic transactions.

For example, under Al Bai Bithaman Ajil (BBA), the transactions are based on "buy" and "sell" thus, the accounting entries MUST reflect both the purchase and then the subsequent sale by the Bank. Thus, the entries must show:

a) 1st Entry - original purchase price (or the amount financed)

b) 2nd Entry - selling price i.e. the original purchase price plus profit margin of the Bank.

The Islamic accounting entries may looked redundant but as earlier mentioned, most Shariah Advisers are agreeable that all Islamic account transactions must be reflected by proper accounting entries.

Chart 2 - Comparative Accounting Entries


As for earnings, we believe nowadays, all Islamic banks (particularly in Malaysia) are earning on accrual basis but from market information, there are still Islamic banks that earn on "cash" basis. The Writer opine that "cash accounting" reflects actual position for profit sharing purpose BUT if the bank is a subsidiary of a conventional bank, it will result difficulty in consolidation and not only that, Financial Analyst may not be able to review bank's actual position vis-a-vis the industry players due to the different accounting practises within the group.

Under progressive release (house under construction), due to the requirement of buy and sell, the accounting entries are slightly different. Unlike conventional banking where loans are released progressively directly from the main account (balance outstanding will increase as loan is progressively released), UNDER Islamic banking, we have to transfer the full sale price into a temporary account (let's name it "Financing Payable Account" and the amount parked in this financing payable account will be released progressively as per Architect's certification.

The accounting entries for progressive disbursement shall be as follows:

Chart 3 - Progressive Release Accounting Entries



NOTE


Kindly take note that the more acceptable product for house under construction (progressive release funding) is Istis'na however in Malaysia, Al-Bai Bithaman Ajil (BBA)  facility is still being used for house under construction. Lately, a number of Islamic banks in Malaysia are moving away from BBA for house under construction.

Nevertheless, the Writer believes that BBA can still be offered (after all the product is actually Murabahah) but it should be structured slightly different from current practise (Method 1) to say, Method 2 and 3 where the Bank actually own the completed Asset and then, sell at a marked-up price. Of course, these later methods will create issue to Risk Dept of the Islamic bank i.e. why should the bank own the asset for sale? The Risk Dept people may not like it but if Islamic banks are serious in offering Islamic banking facilities, the land laws pertaining to property ownership, the bank policies etc. should be changed/tailored towards meeting  Islamic requirements and not the other way i.e. to make Islamic transaction compliant towards meeting existing land laws and bank policies. (We'll discuss more about this under the Shariah issues. Infact, the Writer hopes one day, Islamic bank will joint venture with property developer to build houses etc so, there are no more issues relating to true "buy" and "sell" transaction under BBA/ Murabahah).

Chart 4







Again, the accounting entries MUST reflect the transaction above so the process flow is accounted for.

PROFIT SHARING METHOD
  1. All expenses such as general and administrative cost incurred in operating the banking business will be borne by the Islamic bank and deductible from it's profit sharing portion
  2. The customer's profit portion will be allocated at gross level
  3. Other than fee based income (currently) all other income will have to be part of the "Profit Sharing Pool". Example
Chart 5 - Profit Sharing under Musharakah Financing



On the overhand, under the principle of Mudharabah, profit is shared in accordance with the agreed profit sharing ratio but in situation where there is a loss position, the loss is fully borne by the capital contributor.

Chart 6 - Profit Sharing Under Mudharabah Financing



We shall discuss more about the accounting entries for Musyarakah and Mudharabah Financing once we discuss in detail both concepts in later session of this blog.



ONLY ALLAH KNOWS BEST

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