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

EID MUBARAK !

33B (i) PRACTICAL APPLICATION

a) How to calculate sale price and monthly instalment for fixed profit rate financing?


Using EXCEL formula as per Table 1 , you can calculate the sale price and also the monthly instalment. The formula is typed under column G12 in Table 2.

Table 1 - Calculation Formula

The BBA amortization table as per Table 2 must have column for original purchase price, deposit, amount financed, profit rate, financing period in no. of years, financing period in no. of months (x 12) and the monthly instalment column. The result will be as follows:-

Original Purchase Price :  MYR 100,000.00

Deposit : MYR 20,000.00 (20% down payment)

Amount Financed : MYR 80,000.00

Monthly Instalment : MYR 7,033.27 (using formula Table 1)

Unearned Income : MYR 4,399.25 (profit to Bank or termed as unearned income)

Total Sale Price : MYR 84,393.25

Table 2 - Amortization Table
 
 

Formula to calculate monthly profit is as follows:

1. Monthly profit  : Outstanding principal amount (H18 or 80,000) x profit rate (G9 or 10.00) x Days in the month (D19 or 31 ) divide by 36500 = 679.45 for month 1. To calculate reducing principal amount or cost (iv), take monthly instalment of 7,033.27 minus profit of 679.45 equal to 6,353.82.
2. On line 30, there is extra payment that goes to principal portion (credit 19.20). Since the total sale price is MYR 84,399.25, you can transfer the balance in credit to profit on the final month so the sale price balance will be zerorized.
3. You can copy the formula down all through line C-J18 and C-J30 but make sure you key-in dollar symbol for column   [ $G$9  ] since the profit rate is a fixed constant.

The above tables can be used for manual calculation of profit where income recognition is on cash basis. For cash accounting, the calculation of profits is very straight forward i.e. calculate when you received the payment. 

However, it should be noted that MOST Islamic banks now are using accrual income recognition method where profits shall continue to be calculated (must use system) on the outstanding principal balances bu the UNPAID PROFITS CANNOT BE COMPOUNDED.

Under conventional term loan, whenever monthly instalment is overdue, the unpaid interest portion will be compounded as principal amount (we will show some example in later part of this section)

(b) How to calculate sale price and monthly instalment for FLEXI financing rate structure.

Under Flexi structure, the sale price is also calculated based on fixed profit rate but the pricing is structured where the profit rate is calculated using combination of two (2) pricing components i) BFR - base financing rate; and plus ii) credit spread.

For example, if the BFR is 6.0% and the credit spread is 4.0%, the fixed profit rate to calculate the sale price is 10.0% per annum (known as CPR - contracted profit rate). There is no limit on the credit spread but normal maximum credit spread offered in the market (applicable to Malaysia) is about 4.0% per annum. 

To calculate actual profit , the bank will use EPR (effective profit rate) comprising BFR and agreed credit spread of say, 1-2% per annum (which is normally benchmark against conventional loan in order for the Islamic bank to remain competitive).

One advantage under this structure (which is similar to method (a)), the sale price (based on CPR-contracted profit rate) is also fixed thus, in term of pricing, it is better than the variable interest rate pricing under conventional loan.

On maturity of the financing facility (in most situation), the principal portion will be repaid earlier compared to the (i) unearned income; and (ii) the sale outstanding amount. To close the account, the unearned income need to be rebated (reverse) to zerorise the outstanding sale price (principal balance + balance of unearned income)

To have better understand of the above, let's examine Table 3 below.:

Table 3

Based on Table 3, details of the calculation are as follows:

Amount Financed : RM 100,000.00

Monthly Instalment : RM 3,133.64 (based on EPR)
Unearned Income : RM 16,161.87
Total Sale Price : RM 116,161.87
Flexi Pricing (fixed rate) : BFR 6.0% + 4.0% = 10.0 % per annum
Effective Profit rate (EPR) : 8% p.a. (Y1), 7.75% p.a. (Y2) and 7.50% p.a. (Y3)
Rebate on maturity : RM 3,627.73


(c) Calculation of Sale Price using Flat Rate formula (or Rule 78)

The formula used in computing the monthly installment (if calculation is done manually) as follows:

R = P + (P + I x N)
       ---------------
               N x 12

where   R =  Monthly Installment Payment
            P =  Financing Amount
            I  =  Agreed profit rate
            N =  Financing period

For example

Financing Amount (purchase price) = RM100,000
Financing Period                            =  2 years
Agreed Profit rate                          =  5.0% flat p.a.

Applying the formula:

Monthly Installment =  RM 100,000 + (RM 100,000 x 0.10 x 2)
                                   ------------------------------------------
                                                     2 x 12

                               =  RM 100,000 + RM 10,000
                                   -----------------------------
                                                  24

                                = RM 4, 583.33
                                   ==========


Profit earning calculation:

i) Under Rule of 78 profit earning method, we need to use a formula to calculate the factor that we will use to determine the profit earned for the month out of the total unearned income (i.e.profits due to the Bank).

Formula to calculate factor = 24 x (24+1)/2 = 24 x 25 = 600/2 = 300


Table 4 - Flat Rate %

ii) To calculate the profit profit, we need to calculate the rebate for the remaining months using the following formula:

Every month, similar formula is used to calculate monthly profit. The only changes need to be done is the remaining months.

iii) Profit for the month, for this example; month 1  shall be RM 10,000 - RM 9,200 = RM 800.00

One interesting about flat profit rate calculation is that the above 5.0% p.a. flat profit calculation is actually 9.73% per annum. So, when one wanted to seek financing, always ask whether the profit is calculated on flat rate basis or on monthly rest basis. Simple calculation to determine the effective rate is using this formula

        Profit                                  No. of Days in a Year

-------------------    x   100  x   ----------------------

Financing Amount                       No. of Days in a month

  RM800.00                                    365

-----------------       x  100  x     ------------    = 9.73

RM 100,000.00                              say, 30

There is another profit rate calculation method known as multi-tier profit rates but for this blog, the Writer will not show any example, as the above three (3) profit calculation methods are considered sufficient for the readers to understand on how bank calculates profits on its financing account or loan as known under conventional banking.

The issue here, how or when the profit calculation formula come about? Was it during Prophet Muhammad time or during the time of the shahabat or is it based on conventional formula interest calculation? The obvious answer is that the Islamic banks are using the same formula to calculate their profits. Of course, the Musharakah and Mudharabah financing profit calculation is an exception and we will examine the profit calculation method once we discuss on that subject matter.

We need to answer issues on why Shaikh Imran N. Hosein said that Islamic banks are operating "back-door riba" and why Shiekh Umar Vadillo, known as the father of modern day Islamic gold dinar said that Islamic banking is "triple riba". There are also hadiths that said that it will come a time when modern era Muslim, will find a way to make the riba halal!  Astaqfirullah ! We hope and pray we are not in that era mentioned!  

We shall not discuss the above issues mentioned now but Insha'Allah, we will touch on these issues at later session.

ALLAH KNOWS BEST.

33A. Al Bai Bithaman Ajil - Principle & Concepts

What is Al Bai Bithaman Ajil?

Bai Bithman Ajil (sometime spelt as Bay' Bithaman Ajil) or BBA, is an Islamic financing product involving sale of goods where the sale price is payable on instalment basis. This type of transaction is best referred to as "deferred payment sale". However, in layman term, it's just a purchase of good on credit.

Under conventional banking perspective, banks do not engage in the business of selling goods but grant loans repayable by monthly instalment (or depending on the facility type, repayment can also be on demand basis) where interest (in Islam, interest chargeable by Banks is also considered as usury or riba) is charged until the principal portion (or the original loan amount) is fully repaid.

As mentioned many times in this blog, usury (or interest) is strictly prohibited in Islam. This claim is clearly evidenced by Al Quran verse Al Baqarah (2:275) below:

                                          Extract from website Noble Quran

The keywords of surah Al-Baqarah 275 is that "Trade is like usury but Allah had permitted trade and forbidden usury". Thus, instead of offering the joint venture financing product of Musyarakah (known as Shariah base product which is contrary to Shariah compliant product) during the inception of the first Islamic Bank i.e. Bank Islam Malaysia Bhd (BIMB) in Malaysia in 1983, the Islamic financing product of Murabahah was introduced to meet the above Quranic verse interpretation. Before we define what is "Murabahah" it should be noted that BBA is a Murabahah product but the product name of BBA was given by BBMB to differentiate between a short term (below 12 months) and long-term (above 12 months) tenor financing products.

Now, what is Murabahah? 

Murabahah or murabaha (Arabic مرابحة, more accurately transliterated as murābahah) involves a sale where the seller indicate his original cost of purchasing the good/s (in banking perspective - the original financing amount offered by the Bank) and the mark-up amount (agreed profit rate (%) x financing tenor) as the selling price. In most cases, the buyer would have pay certain amount as deposit (normally 5 - 10% of purchase price) while the balance is payable on instalment basis over the agreed deferred payment period (financing tenor) using the bank financing facility.

If we are to analyze the transaction flow, it is a "trade" transaction (Shariah compliant) but if we are to really view the transaction based on Shariah based interpretation, (explained under Section 30 of this blog) we need to evaluate validity of the transaction based on these requirements:-

ISSUE NO.1

i) is it a REAL trade transaction? What is the real intention of the transaction?

ii) was it a pre-arrange sale to validate the "trade" transaction so as to meet the requirement of Surah Al-Baqarah (2:275) i.e. irrespective it is a bi-lateral or tri-partied transaction; and

iii) why there is issue of "time value on money?" i.e. why sale price differs from one deferred payment period to another, for example the sale price for purchase under deferred payment sale of say, one (1) year is different from say, ten (10) years?.

We shall discuss all Shariah related issues (will be numbered accordingly as above) when readers have fully understood basic modus operandi (or transaction flow according to most common prevailing banking practises in Malaysia) of Murabahah/BBA. We shall examine all the issues based on practitioners' point of views versus opinion of Islamic scholars who are in favour and those who are against the princple of "deferred payment contract" product. We are not trying to create confusion among the readers of this blog but seeking consensus among the scholars (who mostly does not have banking experience) but raise issues on validity of product.

Irrespective the above-mentioned issues, conceptually, Murabahah/BBA involves the followings:

• Based on BUYING and SELLING concepts where all these five (5) tenets must be available:

   i.     Seller/Vendor
   ii.   Buyer/Purchaser
   iii.  Goods/Assets
   iv.  Price/Consideration
   v.   Akad/Contract (Offer & Acceptance)

The contract of buying & selling is established upon full completion of all 5 tenets above.

• Sell at FIXED price (principal amount plus fixed profit margin i.e. for whole financing tenor);

• Bank’s PROFIT MARGIN is based on BUYING and SELLING; NOT from money LENT out as loans;

• Sale price is the CEILING AMOUNT (the Writer opine that BBA can be considered a hedge product since its sale price is fixed throughout the financing period vis-a-vis a variable conventional interest rate environment ) that the bank can claim or amount due from the buyer (or customer);

• Goods delivered upfront and must be also be free from all encumbrances (seller has valid title or ownership over the goods)

• Financing tenor can be from short, medium to long term basis.

The Bai Bithaman Ajil/Murabahah facility can be graphically explained according to the following chart :
 
Chart 1
 

The property purchase transaction has to undergo the normal legal documentation prior release of the funds to the developer/vendor but in short, the transaction flow (acceptable in Malaysia) process based on the above graphical chart is as follows:-

1. Buyer (customer) identified an asset to be sold by a vendor, where the asset can be either:

• a property under construction (where bank will release the amount financed progressively according to architect's claims), or
• a completed house (e.g. house for sale by first owner);

ISSUES NO.2

i). Are we using the right contract or Islamic principle? i.e. BBA to purchase house under construction? Some scholars said that the Banks should be selling tangible asset instead of selling "a non existence asset" since the house is yet to be constructed;

ii). Should the right contract for house under contruction be "istis'na or Sale by Order?"

2. Buyer will sign the Sale & Purchase (S&P) Agreement with the developer/vendor and pay certain agreed down-payment (or just a booking fee first) to indicate Buyer's commitment to purchase the house;

3. Buyer cannot afford to pay cash for the purchase thus, Buyer will approach an Islamic Bank to finance the purchase;

4. Based on the Buyer's S&P Agreement with developer/vendor, Bank will sign a Novation Agreement (some banks, discard this practice) and the Property Purchase Agreement (PPA) with the Buyer. When the Bank signed the PPA, the Bank become the beneficiary owner of the house;

5. Upon completion of the normal legal requirement processes, the Bank will pay the vendor in full (or progressively) to complete the sale transaction. Prior releasing the funds, the Bank will sign the Property Sale Agreement (PSA) with the Customer indicating that it has sold the property to the Customer.

6. The Customer will pay the deferred installment amount on monthly basis until full settlement.

POINT TO NOTE

i. Murabaha/BBA is a Shariah CONTRACT/MODE OF PAYMENT. If the transaction is on bi-lateral basis (involves only 2 party), then the contract is known as Bai Al-Inah.

ii. The buying and selling transaction between the Bank and customer does not involve legal transfer of ownership. However under Shariah (Malaysian view), the buy and sell transaction is considered genuine sale where the rights over the property is transferred although on paper the house is not registered in Bank's name;

iii. Real Property Gain Tax (RPGT) that should have been derived from the buy and sell transaction (if any), is exempted.

iv. The principal financing document is Asset Sale Agreement.

v. Stamping is on “ad valorem” basis (RM5 per RM1,000 financing amount) but on the Bank’s Purchase Price (Amount Financed).

vi. The underlying asset for transaction not necessary be charged as Collateral since collateral is considered administrative matter. However in practice, the owner's name will be registered as the owner in the land office registry while the Bank will have a charge over the property;

vii. Stamp duties for re-financing from conventional to Islamic, is exempted. Facility in excess of original financing amount, stamp duties chargeable only on additional amount. Will also enjoy 20% stamp duty remission for new facility (this remission may be one day be retracted by the Government to ensure level playing field with the conventional bank);

Before we close this section, the Writer would like to show other verses in the Quran ( Surah Al-Baqarah) that explains Muslims must keep away from usury or riba.

Surah Al Baqarah (2:276) - Allah deprive usury from ALL BLESSING.

Surah Al Baqarah (2:278) and (2:279). More importantly is surah 279 since Allah and the prophet declares WAR to those who deal in usury or riba.

Allah knows best.

33. Al Baithaman Ajil/Murabahah

We shall discuss above-mentioned topic under five (5) sections, namely

A. Product principle/concepts;
B. Practical application (including simple accounting entries);
C. Comparative analysis;
D. Legal issues (Malaysia law);
E. Shariah issues and resolution.

We shall not discuss all the above in detail but the Writer's approach is to provide enough information for readers of this blog to understand the about the product. Similar approach will also be used in discussing other Syariah compliant products as mentioned under section 32.

Allah knows best.

32-List of Islamic financing products

List of financing concept/products that we shall discuss in detail are listed below:

Debt Financing

Al-Bai' Bithaman Ajil/Bai' Muajjal (Deferred Payment Sale)
Al-Murabahah (Cost Plus)
Tawarruq (Commodity Murabahah)
Al-Qard (benevolent loan)
Bai’ as-Salam (future delivery)
Bai’ Al-Istijrar (supply contract)
Ar-Rahnu (collateralised borrowing/Pawn Broking)
Bai' al 'inah (sale and buy-back agreement/Credit Card/personal financing)


Lease Financing

Al-Ijarah Thumma al-Bai’ (leasing and subsequently purchase)
Al-Ijarah (leasing)
Al-Istis'na Ijarah

Debt Trading
Bai’ al-Dayn (debt trading/block discounting)

Equity Financing
Al-Mudharabah (profit-sharing)
Musyarakah Muntanaqisah (Diminishing Musyarakah)
Al-Musyarakah (joint venture)

Trade Finance

Letter of Credit (Wakalah/Musharakah/Murabahah)
Trust Receipts (Murabahah)
Al-Kafalah (Bank Guarantee)
Export Credit Refinancing (Murabahah/Al-Dayn)
Accepted Bill (Murabahah/Al-Dayn)

Fee/Commission

Al-Hiwalah (remittance)
As-Sarf (foreign exchange)
Al-Ujr (fee)
Al-Hibah (gift)

Capital Market
Sukuk (Debt/Lease/Wakalah)
Islamic Unit Trust
Islamic REITS
Islamic Derivatives
Structured Products

All the above products have been offered by Islamic Financial Institutions (including widow operators in Malaysia). My approach in describing these products shall be towards practical aspects, including highlighting some of the constraints in implementing the products and also some legal issues relating to it (Malaysian legal aspects).

From Writer's own experience, most of the Islamic banking products are well documented but sometimes, the products can be rendered as non-shariah compliant (whether the users are aware of it, is a challenge), when it comes to implementation. Examples (to highlight a few) on how the products can be rendered as non-Shariah compliant are as follows:

a) using conventional accounting entries instead of Islamic accounting entries;
b) signing of sale agreement first instead of purchase agreement when signing legal documents of debt (trade) related products;
c) using wrong terminology in legal documents etc.

Of course, these products are not spared from critics thus the Writer shall highlight some of the differences in term of opinion (basically, not to confuse the reader but to analyse what are the differences and what consensus can be reached for better understanding and offering of the products). In addition, the Writer shall also provide comparative analysis vis-a-vis conventional banking products.

To ensure, Islamic banking income are not tainted due to wrong processes (basically due to lack of experience and sometime due to staff working attitude etc), those responsible (in Malaysia now, it's the responsibility of Shariah audit and Shariah review staff in the Islamic banks) must be able to trace these discrepancies so that tainted income will not be mixed with "halal income" where unknowingly we are depriving income from Islamic banks of Allah's blessing according to surah Al-Baqarah (276) that reads as follows:

"Allah does not bless usury, and He causes charitable deeds to prosper, and Allah does not love any ungrateful sinner" ( سورة البقرة , Al-Baqarah).

IslamicBankingWay.Com
ALLAH KNOWS BEST.

31- Brief Development on Islamic Finance in Malaysia

This brief update was extracted from the Economic Report (Star Special, Saturday 8 October 2011) and Bloomberg (7 October 2011)


July 1, 2011

The Shariah Governance Framework was implemented to further strengthen the oversight role, authority, accountability, independence and competency of the Board of Directors, the Shariah Committee and the Management of the Islamic Financial Institutions on Shariah matters.

First half of 2011

Two Islamic indexes were launched namely:

a) the Bloomberg Malaysian Foreign Currency Sukuk Index (a non-Ringgit denomination index developed to provide global benchmark for the performance of Sukuk and the avability to track movement of foreign currency); and

b) Bloomberg-AIBIM-Bursa Malaysia Sovereign Shariah Index - collaboration between Bloomberg.

End of July 2011

# 847 Shariah compliant securities were hosted on Bursa Malaysia, representing 89% of the total listed securities with a market capitalisation of RM826 billion or 61.7% of total market capitalisation (end 2010: RM756.1 billion or 59.3%);

# Malaysia remained a leader in global sukuk market outstanding and Bursa Malaysia is also the top sukuk listing destination, with 19 sukuk totalling RM88.3 billion (USD29.6 billion);

# Fully fledged Islamic fund management companies is 16 and 160 unit trust funds with total net asset value RM26.4 billion (end 2010 : 152 funds:RM24 bil)

# Islamic wholesale funds launched stood at 24 (end 2010: 19 funds) with size in terms of net asset value (NAV) of RM7 billion (end 2010: RM4.2 Billion);

# One (1) Islamic exchange traded fund is listed with NAV of RM579 million and Islamic real estate investment funds (REITs) stood at 3 with market capitalisation of RM2.5 billion as end of June 2011;

# Asset of Takaful industry grew 16.8% to RM16.3 billion, accounting to 8.7% of total assets in the insurance and takaful sectors. Market penetration rate of family takaful improved to 12.1% (end 2010: 10.9%). For General takaful sector, gross direct contribution increased 18.1% to RM917.5 million (Jan-July 2010: 27.6% or RM776,7 mill, due to higher contribution from motor and medical business

# Malaysia's Islamic banking assets rose 15 percent to RM389.3 billion, strengthening the country's position as the global hub of Shariah compliant financing. Based on total banking system. Financing asset increased to 17 percent (RM246.8 billion) and make up 23 percent of total loans and financing, while deposits grew 14 percent to RM299.1 billion;

# Islamic insurance, or takaful, assets rose 17 percent to 16.3 billion ringgit at the end of July from the same period last year, according to the report. The sector accounted for 8.7 percent of Malaysia’s total insurance industry as of July 31, up from 8.3 percent a year earlier.

 
IslamicBankingWay.Com
ALLAH KNOWS BEST