Chapter 7: Islamic Commercial Contracts

Discussion Questions1. What are the two systems of secular law in the world?

The common law system of England and Continental/ Civil law system of law in continental Europe.

2. [2.] Is there any other religious law in the world besides the shariah?

What are these and where are they practiced?

Yes, Hindu Family Law- India , Canon Law by the Church

3.

[3.] [4.] Explain the differences between shariah and fiqh.

The shariah consist of legal principles and a few rlws in the Quran and Sunnah, whereas fiqh provide the detailed rules of the shariah through a process of derivation this from the sources of the shariah.

4. [5.] [6.] Categorize the shariah into the main components and give a brief

explanation of each.

The shariah consist of:

Ibadah: rituals, creed and worship Akhlaq: Ethics and moral character Muamalat: transactions including civil, family and criminal

5.[7.] [8.] What do you think are the main objectives of Islamic contracts?

Derive these from the pillars and rules of Islamic contracts.

Justice and fairness for all parties and mutual consent. Pillars ensure that there is a contract, it is not for prohibited

things, parties have capacities to contract, and the substance of the contract exists.

Rules/ Conditions ensure that contracts are not vitiated by absence of real consent e.g. ambiguity, contingency, inequality, coercion, duress, deception or threat

6. [9.] [10.]

[11.] What is the difference between Qard and Dayn?Qard is a loan of money, whereas Dayn is a debt which arises from a

transaction in which payment is deferred.

7.[12.] What are the pillars of Islamic contracts. State and explain briefly.

Pillars are:

i. Offer and acceptanceii. Existence, legality and ownership of subject matter iii. Legal Capacity to contract

8.[13.] [14.] [15.] Explain the prohibited elements in Islamic contracts. [16.]

Riba, interest given or taken Gharaar – ambiguity and uncertainty Elements of Maysir or gambling Prohibited subject matter or purpose e.g pork, prostitution

9.[17.] [18.] What elements makes an Islamic contracts defective or invalid

besides the prohibited elements in question 8. Deception, Undue influence, force or duress Mistake Inequality

10. .

Differentiate between mudharabah, musharakah and murabaha.

Mudharabah is a partnership where one partner contribute capital and the other contribute effort or expertise, both share in profits but losses are only borne by the capital contributor bit in musharakah both contribute capital and share in losses as well. Murabaha on the other hand is a sale in which cost and profit is disclosed to the buyer and payment is usually deferred in Islamic finance application.

Exercises1. [1.]

[2.] [3.] Exercises[4.] [5.] Search the website of an Islamic Bank in Malaysia and one Bank in

Bahrain and list the deposit and financing products. What are the underlying contracts in these products? Are the underlying contracts the same in the Malaysian and Middle East Banks?

In Malaysia, mostly wadiah is used for current and savings account deposits but in Middle East. Qard Hasan is used. Bai Bithaman Ajil is used in Malaysia but not in the Middle East.

2. Categorise the following contracts as valid, invalid or imperfect.a. An Islamic bank provides financing to build a Masjid - vValid

b. Rajoo Islamic bank provides interests to its depositors. - Invalid

c. Ali signs up for a family takaful policy (similar to life insurance). -

vValid

d. An Islamic bank in country X enters into an istisna contract to finance the building of a prostitution centre. Prostitution is legal in the country. -

Invalid as it is still prohibited by the shariah.

e. An Islamic bank provides murabaha financing for a car already owned by Ahmad. -

Invalid as the bank cannot sell what it does not own.

f. An underaged boy enters into a loan agreement with his friend. - Imperfect unless approved by guardian

g. Kathija is forced to sell her car for $10000 (less than the market value) to Kevin by Nathan who is a paraplegic on a wheel chair. -

Valid as Nathan is incapable of carrying out any threat

3. Restructuring the Mudaharabah contract: Hussain enters into a mudharabah agreement with Hasan who will be the mudharib. The terms of the agreement are as follows:

a. Hasan gets $4,000 monthly salary whereas Hussain gets 5% of his capital amount every year in addition to any profits, even in the case of losses.

b. Hussain provides 70% of the capital, Hasan provides the rest.c. Hussain and Hassan share the profits and losses equally.d. Losses are shared by Hussain and Hassan in the capital

contribution ratioe. Hussain will take an active part in the management of the

mudharabah.

Discuss the above scenario from the fiqh point of view of a mudharaba contract. If you are called to advise the partners regarding the compliance of the shariah, how will you restructure the contract to be according to mudharabah principles. What other option is available if the partners do not want to make too many changes to their contract.

Answer:The above contract is invalid because: Rabbul maal cannot be paid a return on capital and cannot

take an active part in Management. Further Mudharib cannot get a salary, do not contribute capital and share losses. These conditions must be removed, and profit sharing ration must be agreed.

Suggest a musharakah contract where both can share losses but not equally, both can participate in management and provide capital. Hasan can also be paid a salary for managing the business.or a higher profit share.

Chapter 8: Application of Islamic Financial Contracts to Accounting

Solution Manual

Multiple Choice Questions:

1. What is of the following is correct, when ibra is recorded in the accounts?

a. It shall be debited to the Murabaha Financing account.

b. It shall be treated as a liability.

c. It shall be taken out of the deferred profit account and credited to Murabaha Financing.

d. It shall be credited to the Murabaha Payables account and debited to cash.

2. Which of the following is incorrect?

a. The contract of murabaha requires that the markup (profit) must be recognized equally over the murabaha contract period.

b. In murabaha financing, the selling price must be fixed without any hidden cost.

c. The contract of murabaha allows for early redemption with rebate on the unearned income.

d. Late payment charges levied by the bank are allowed by AAOIFI but should be given to the charity if directed by the Sharia committee and should not be compounded.

3. Identify the correct action of Islamic Bank in the following case study: Mr. Bilal made a binding promise to an Islamic Bank that he would buy a van from the latter through a murabaha transaction. Based on that promise, the Islamic Bank collected urboun of US$500 from him, and bought a van from a vendor for US$30,000 in cash. After the van was delivered to the Islamic Bank, Mr. ABC decided not to buy it. The Islamic Bank then sold the van to John in a forced sale, for US$29,800 in cash.

a. The Islamic Bank should return US$300 to Bilal

b. The Islamic Bank should return US$500 to Bilal.

c. The Islamic Bank should not return any money to Bilal.

d. The Islamic Bank should not return any money to Bilal but must pay US$300 to John as a gift to be thankful to John for being willing to buy the van.

4. Which is the most common contract for personal financing being employed by Islamic Banks?

a. Murabaha

b. Musharaka

c. Tawarruq

d. Mudharaba

5. Identify the correct journal entries at the time of contracting the murabaha contract under the following scenario: An Islamic Bank enters into a murabaha financing agreement for a plant at cost $300,000 and profit of $100,000. It has purchased the asset already.

a. Debit: Murabaha Financing; Credit: Equipment and Deferred Profit

b. Debit: Cash; Credit: Equipment and Deferred Profit

c. Debit: Murabaha Financing; Credit: Cash and Profit with the appropriate amounts

d. Debit: Murabaha Financing; Credit: Accounts Payable and Deferred Profit

Questions 6 to 10 are based on the scenario of Jordan Islamic Bank given below:

Jordan Islamic Bank gave a Murabaha financing to Ahmad to purchase a house that cost the bank 200,000 Dinars over a 10-year period. The mark up was a constant rate of return of 10% per annum. The installments are to be paid equally over the 10 years. The bank recognizes profit equally over the period. Ahmad paid the installments regularly for the first 4 years and at the end of the fifth year he redeemed the financing. Jordan Islamic Bank agreed to give Ahmad 80% of the unearned deferred profit at the end of year five, after taking the full profit for year 5.

6. Which of the following is the correct entry on receipt of installments of year 1, including recognition of profit.

a. Dr Cash 40,000 Cr Murabaha Financing 40,000

Dr Deferred Profit 30,000 Cr Profit and Loss 30,000

b. Dr Cash 40,000 Cr Murabaha Financing 40,000

Dr Deferred Profit 20,000 Cr Profit and Loss 20,000

c. Dr Cash 40,000 Cr Murabaha Financing 40,000

Dr Profit and Loss 20,000 Cr Deferred Profit 20,000

d. Dr Murabaha Financing 40,000 Cr Cash 40,000

Dr Profit and Loss 20,000 Cr Deferred Profit 20,000

7. Which of the following is the correct extract of the balance sheet of Islamic Bank of Jordan at the end of the second year after the second installment is paid.

a. Murabaha Financing 200,000

b. Murabaha Financing 320,000

c. Musharaka Financing 320,000

d. Murabaha Financing 400,000

8. Which of the following is the correct extract of the Income statement of Islamic Bank of Jordan at the end of the 1st year.

a. Profit/(loss) from Murabaha Financing (20,000)

b. Profit/(loss) from Murabaha Financing 20,000

c. Profit/(loss) from Murabaha Financing 200,000

d. Profit/(loss) from Murabaha Financing 40,000

9. Which of the following shows the correct balance of deferred profit account of Islamic Bank of Jordan at the end of the 5th year after the payment of the 5th installment but before redemption

a. 80,000

b. 120,000

c. 100,000

d. 200,000

10. Which pair of the following figures shows the redemption amount (assume the installment for the fifth year have been paid separately before redemption ) and the total profit taken in the 5th year.

a. Redemption amount 120,000, Profit recognized for year 20,000

b. Redemption amount 200,000, Profit recognized for year 40,000

c. Redemption amount 200,000, Profit recognized for year 120,000

d. Redemption amount 120,000, Profit recognized for year 40,000

Discussion Questions:

What are the reasons for the failure for mudharaba and musharaka contracts to become mainstream in the Islamic Financial Service Industry?

The reason for the failure for thses contracts to take off is the presence of agency costs as compared to a loan. These means the mudharib can consume perks as well as incur unnecessary expenses and end up with a loss for which he is not responsible. There is also a risk of moral hazard in that the mudharib can choose risky projects and nd up in loss for investor.

Suggests ideas to make Mudharaba and Musharaka contracts mainstream in the Islamic Financial Industry.

Using an risk based investment pool mechanism which will enable investors to invest according to their risk appetite.

Have legally enforcible code of conduct for banks on investing of funds

Shift onus of proof of negligence or incompetency to the bank.

Have independent audit and monitoring mechanism for each risk pool.

Have a hurdle rate based on average return on similar risk equitiy return as a benchmark and in case any losses or return way below the hurdle rate, bank will have to prove it was not negligent or incompetent failing which they have to pay a penalty or return the capital.

You were introduced to urboun (a non refundable deposit) in this chapter, use Google to find the meaning of another deposit termed hamish al jiddiyah, which is refundable. Explain what is the difference between urboun and Hamish Jiddiyah in your own words. Do not cut and paste or memorize.

What Is the Difference Between Hamish al-Jiddiyyah and Urboun?

Hamish al-jiddiyyah is a security deposit received by the purchaser/reseller in a murabaha to the purchase orderer (MPO) from the potential buyer upon the request of the latter to buy a specific asset/commodity either on credit (for the purpose of financing) or in cash (for the purpose of seeking the market expertise of the purchaser/reseller). This deposit is designed to help the purchaser/reseller make sure that the orderer is serious in his request of purchasing the object of sale. However, if the orderer refuses to purchase the object, the actual damage incurred by the purchaser/reseller should be covered using hamish al-jiddiyyah. The purchaser/reseller may have access to hamish al-jiddiyyah for the amount of actual damage he incurred due to the odrerer’s refusal to conclude the contract of sale. If hamish al-jiddiyyah falls short of the amount of actual damage, the purchaser/reseller may have recourse to the orderer for any remaining amount.

Urboun (arboun or arbun), on the other hand, is an amount of money paid in advance by the potential buyer to the seller in order to secure the sale. If the buyer chooses to proceed with the deal by taking the object of sale then this amount will be considered as part of the price paid in advance. Otherwise, it will be retained by the seller and the buyer will expect no refund whatsoever.

In view of both definitions, the purchaser/reseller retains the full amount of urboun whether it is enough to cover the damages or not. This is not the case with hamish al-jiddiyyah, as the purchaser/reseller is entitled to deduct only an amount equal to the actual damages incurred by him. If hamish al-jiddiyyah is less than the amount of loss, the purchaser/reseller may request the orderer to pay down the difference. If it exceeds the amount of loss, the purchaser/reseller will have to refund the difference.

Downloaded using google search from https://www.investment-and-finance.net/islamic-finance/questions/what-is-the-difference-between-hamish-al-jiddiyyah-and-urboun.html

(students should use their own words instead of copying and pasting)

After referring to the internet or other references to obtain a knowledge of Hamish Jiddiya, draft and discuss the journal entries to account for Hamish Jiddiyah deposit of $5000 and its refund where the bank lost $1000 due to the customer not keeping his promise and the promise was binding. Use your knowledge of double entry book keeping, do not copy from other resources.

Dr Hamish Jiddiyah deposit $5,000

Cr cash (refund) $4,000

Cr P/L (recovery of losseses) $1,000

Draw a diagram showing how a customer using tawarruq can place a deposit in a bank with a fixed return.

Answer:

1.Deposit $1000

Customer Bank Trader B

Trader A

2. Buy on behalf of customer cash basis $1000

3.Transfer ownership to customer

4. Sell to Bank on Murabaha $1100 deferred

6. Cash paid to bank $1000

7. bank pays back customer $1100 on maturity

5.Bank sells to B cash basis $1000

Do you think IFRS accounting standards are suitable for Islamic accounting, given that Islamic accounting have different social, religious and economic objectives as opposed to the capitalist market nature of IFRS?

No, as they are meant for a capitalistic economy and not be compliant to the shariah.

Research the Accounting and Auditing Organization and make a 10 minute presentation in class. Conduct a class discussion for 5 minutes after your presentation on whether AAOIFI should continue its work on accounting and other standards given that world is converging to IFRS standards.

Presentation should contain history, objectives, structure and output of AAOIFI. AAOIFI should continue is work because we have different objectives.

Explain the concept of time value of money. Search for references on the Islamic perspective on this concept and discuss why you agree or disagree with this concept.

TVOM assumes that $1 obtained in the future is less than the $1 obtained today because of opportunity costs.Time value of momey may lead to justification of riba. Under Islam, money is a not a commodity, it is a medium of exchange.

Looking at the illustration in this chapter, discuss which accounting standard (IFRS or AAOIFI) is more beneficial to the customer if he wants to redeem his murabaha financing in 5th year of a 8 year murabaha contract?

This depends on the time of redemption. Generally, the AAOIFI standard using straight line method of profit recognition is beneficial if redemption is in earlir or later years but IFRS amortised cost method is beneficial in case of early redemption only.

Using the definition of assets, liability and equity, explain in your words the logic of the accounting entries under AAOIFI for a simple murabaha transaction with deposit but without early redemption, from beginning to end.

Deposit received by a bank is a liability therefor credited while the asset cash and asset is debited.

On purchase of equipment, the equipment is debited as it increases this asset and decrease cash , thus cash is credited.

On sale to customer equipment ownership is transferred to them thus asset is taken out of the bank balance sheet and replaced with the debt due consisting of the murabaha price to the Murabaha financing account.

The profit is not recognized at point of sale but deferred over the period of financing. Hence, the profit is suspended in a deferred profit account by crediting this account.

On receipt of installments cash is received and debited, ,while the debt (Murabaha financing) decreases , thus it is credited. Meanwhile the profit recognized for the period is credited of the P/L, while deferred profit is reduced accordingly by debiting it.

Exercises

Wan Rosli places a tawarruq deposit with Maybank Islamic for a period of 8 years. The Murabaha Selling price of $10,000 to the bank is based on a return of 5% per annum compounded. Using the PV of $1 table, calculate the amount that is placed in the bank.

Here we have to find the present value of $10,000 discounted at 5%

Over 8 years, thus,

Using the present value of $1 table, at 5% per annum for 8 years, the discount factor is 0.67684, we multiply this by $10,000 to get $6,768.40 as the deposit we need to make at the bank.

2. Othman al Habshi needs $50,000 for his son’s wedding. He decided to seek Islamic financing using tawarruq financing from Bank Islam of Yemen with a term of 10 years. If the bank uses a 7% compound rate a year and Othman intends to pay 10 equal annual installments, calculate using Excel or formula or relevant financial table, the amount of installment he has to pay per year.

Hint: Use the =pmt Excel formula or the formula given in this chapter with the help of tables.

Answer:

Using the following formula in excel, =PMT(0.07,10,50000). Othman has to pay $7,118.88 per year for 10 years, if he needs $50,000.

The Baghdad Islamic Bank sold on a murabaha basis a house to Imam Ghazali at a mark up of 8% per annum constant rate of return to be paid over 10 years in equal annual installments. The cost of the House was 50,000 Dinars and Imam Ghazali paid 10,000 dinars as deposit. Baghdad Islamic Banks follows Islamic Accounting Standards and recognized profits according to installments due. Imam Ghazali paid the installments for the first 2 years but was late in paying the 3rd installment by one month (which he paid together with the tawid). The bank charged him ta’wid 10 dinar which would be payable to charity. At the end of the 4th year, the Khalifa Harun Al Rashid gifted Imam Ghazali, a bounty for his magnum opus “Ihya ulumuddeen” of 60,000 Dinars. The Imam decided to redeem his house financing, keep a balance of 10,000 Dinars for his expenses and give the balance as sadaqah to achieve the pleasure of Allah swt. Baghdad bank gave him a full rebate on the unearned profits for the remaining period of the original Murabaha contract, which was redeemed on the last date of the 4th year. Alhamdulillah, the Imam was able to give the intended amount of the sadaqah in Ramadhan as the moon was sighted on the last day the 4th year of the murabaha contract. How much sadaqah did he give?

Murabaha price is 8% x10 yrs 40,000 (cost of financing;50,000-10,000 deposit)+40,000 =32000+40,000=72,000

Annual instalment is =72000/10=7,200 dinars per year.

Instalments paid for 4 years= 7200x4= 28,800

Amount of profit recognized = 32,000/10x4= 12,800

Balance of unearned profit at end of 4th year= 32000-12,800= 19,200 . This is the rebate given.

Therefore redemption amount is 72,000- 28,800- 19,200= 24,800.

The amount of sadaqah given by Imam Ghazali is 60,000-10,000-24,800=25,200 dinars

Using the facts in E3, if the IFRS accounting recognition method is used, how much charity will Imam Ghazali will be able to give? Explain the difference.

We need to construct a amortization table to answer this question, thus

profit @

Instalment

balance of debt

yrfinancing 0.08

due at yr end paid

after instalment

1 40000 3200 43200 7200 36000

2 36000 2880 38880 7200 31680

3 31680 2534 34214 7200 27014

4 27014 2161 29176 7200 21976

From the table above, we can see that the redemption amount is

$21,976. Hence Imam Ghazali will have (60,000-10,000-21,976) to give as sadaqah This works out to $28,024 compared to $25,200 under AAOIFI method.

The reason is the redemption amount is less because profit is recognized for the four years are less compared with that recognized under equal recognition method of AAOIFI leaving more for sadaqah. This is due to profit based on principal balance compared to constant rate on the original financing (AAOIFI) which is higher.

5. Using the data in the Comprehensive Illustration given in this chapter, record the entries in the following ledger accounts and close off the accounts each year until early redemption, under AAOIFI accounting standards only.

Murabaha Financing, Deferred Profit, Cash, Profit and Loss, Deposit Payable, and Equipment Accounts.

Murabaha Financing

Equipment cost 40 1 Cash 1st instalment 10

Mark up- Deferred Profit 10 1 Instalment 2 10

2 Instalment 3 10

Deferred Profit 4

Cash 1st instalment 16

50 50

Deferred Profit

1 Profit and Loss 2MurabahaFinancing 10

2 Profit and Loss 2

3 Profit and Loss 2

Muraba Financing rebate 4

10 10

Cash

1 Deposit payable urboun 10Equipment 50

1 Instalment 1 10

2 Instalment 2 10

3 Instalment 3 10

Muraba Financing- redemption 16

Profit and Loss

1 Defered Profit 2

2 Defered Profit 2

3 Defered Profit 2

Deposit Payable

Equipment Purchase 10 Cash Urboun 10

Equipment

Cash purchase 50 Deposit payable 10

Murabaha Financing 40

50 50