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 2) In installments 3) 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).

Bank

Agreement to Murabaha

Client

Process Flow Murabaha Financing 2. Client appointed as an agent to purchase goods on the Banks behalf.

Bank

Agreement to Murabaha Agency Agreement

Client

Process Flow Murabaha Financing

3. Bank gives money to an agent/supplier for purchase of goods.

Bank

Agreement to Murabaha Agency Agreement

Client

Disbursement to the agent or supplier

Supplier

Process Flow Murabaha Financing

4. The agent takes possession of goods on the Banks behalf.

Transfer of Risk

Vendor

Delivery of goods

Bank

Agent

Process Flow Murabaha Financing

5(a). Client makes an offer to purchase the goods from the Bank through a declaration.

Bank
Offer to purchase

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)

Bank

Payment of Price

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) 2) Agency Agreement

3) Draw Down Notice

4) Summary Payment Schedule 5) Declaration

6) 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

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.

Accounting Policy for Murabaha

Revenue Recognition
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.
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..

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.

Case Study for Murabaha Below is the case study for the understanding of Murabaha transactions carried out at Meezan Bank in various scenarios:

Example Purchase price/Cost/Principal Profit Rate Tenure Total profit on transaction Sale price (Contract price) Date of Disbursement to supplier/customer Date of Culmination of Murabaha Transaction Date of Maturity of Murabaha

Amount in Rs./%

1,000 10%

One year 100 1,100 January 01,2007 January 15,2007 December 31, 2007

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) Cr Pay Order / Party Account (B/S Liability side) 1,000

1,000

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 Dr Cr Cr Murabaha Financing Unearned Murabaha Profit Receivable Advance against Murabaha Deferred Murabaha Income 1,000 100 1,000 100

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]: January 15, 2007

Dr Dr Cr Cr

Deferred Murabaha Income Murabaha Profit Receivable Income on Murabaha Financing Unearned Murabaha Profit Receivable

4.10 4.10
4.10 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 Dr Cr Cr

Deferred Murabaha Income 4.39 Murabaha Profit Receivable 4.39 Income on Murabaha Financing 4.39 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 Less: Deferred Murabaha Income {100- (1000x10%x31/365)} Murabaha Profit Receivable shown in other assets Murabaha Financing Receivable

1,100 (91.51) (8.49) 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 Cr Cr

Party Bank A/c Murabaha Financing Murabaha Profit Receivable

1,100

1,000 100

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 Cr

Advance against Murabaha Pay Order / Party Account

1,000 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.

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 Dr Cr Cr

Murabaha Financing Unearned Murabaha Profit Receivable Advance against Murabaha Deferred Murabaha Income

1,000 100
1,000 100

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 Dr Cr Cr

Deferred Murabaha Income 12.60 Murabaha Profit Receivable 12.60 Income on Murabaha Financing 12.60 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 Dr Cr Cr

Deferred Murabaha Income 3.56 Murabaha Profit Receivable 3.56 Income on Murabaha Financing Unearned Murabaha Profit Receivable

3.56 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 Less: Deferred Murabaha Income{100- (1000x10%x(31+28)/365)} Murabaha Profit Receivable shown in other assets Murabaha Financing Receivable 1,100 (83.84) (16.16) 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 Cr Cr

Party Bank A/c Murabaha Financing Murabaha Profit Receivable

1,100 1,000 100

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: 1) Bank is holding assets for future sale to its customers against a promise 2) The Goods are imported as Banks agent and are not sold to the importers i.e. they are in PAD 3) Any other reason due to which the goods remain unsold.

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