an Introduction to Islamic Finance
ANINTRODUCTIONTOISLAMIC FINANCE1
CONTENTSMusharakahMudarabahMurabahahIjarahSalam and Istisna2
Musharakah
Musharakah is an arabic word which means sharingmeans
participation of two or more persons in a certain business with
defined amount of capital according to a contract for jointly
carrying out a business and for sharing profit and loss in
specified proportions3
2 broad categories:
Sharikah al-mulk i.e property partnership
Sharikah al-aqd i.e contractual partnership
5 types of Sharikah al-aqd:
Sharikah al-mal or finance partnership
Sharikah al-amal or labour partnership
Sharikah al-wujuh or credit partnership
Sharikah al-inan or limited investment partnership
Sharikah al mufawadah or unlimited investment
Musharakah4
Sharikah al-mulk
The origin of the partnership is the joint ownership of
property.Joint ownership is its only qualification, and no joint
exploitation of property is necessary. It occurs when two or more
people are partners in the possession of property. 5
Sharikah al-mulkThe rule governing this type of sharikah is that
any increase in the property shall be shared by the co-owners in
proportion with the extent of their ownership. Each of them is in
the category of a stranger in regard to any action on the part
owned by his colleague. It is unlawful for either partner to
perform any act with respect to the others share except with the
latters express permission. 6
Sharikah al-mulkIn terms of liability of the partners, they are
quite independent of each other, except for actions based on
express authorization by any of the partners. Their partnership is
only in terms of ownership and potential sharing of any profit or
increase in the co-owned property, not in term of sharing the
liabilities arising from the partners actions.
7
Sharikah al-mulkThis type of sharikah may not be known in the
common law. In fact mere joint-ownership is generally insufficient
to constitute a partnership in common law.
8
Sharikah al-aqd
The origin of the partnership is the contract between the
parties. The structure of this type of sharikah may have more
similarities with the normal partnership in common law. For
sharikah al `aqd, joint ownership is not an element necessary for
the establishment of the partnership. 9
Sharikah al-aqd
The emphasis is rather on the joint exploitation of capital and
the joint participation in profits and losses, based on the terms
of the partnership contract. Joint ownership is one possible
consequence, and not a prerequisite for the formation of sharikah
al `aqd10
Sharikah al-aqd
The jurists further sub-divide Sharikah Al Aqd into various
other categories. The subdivisions depend on a number of factors.
If the underlying factor is the subject matter of capital
contribution, sharikah al `aqd can be sub-divided into three main
categories:-(1)sharikah al amwal, (2)sharikah al a`mal (3)sharikah
al wujuh.
11
Sharikah al-aqd
When the subject matter of the capital is money, it becomes
sharikah al amwal (monetary partnership). If the capital is in the
form of labour, it becomes sharikah al a`mal (labour
partnership).If the capital is in the form of reputation or
creditworthiness, it becomes sharikah al wujuh (reputation
partnership).
12
Sharikah al-aqd
The jurists also make further sub-divisions to sharikah al `aqd
based on the terms of the contract, i.e., whether the partners are
required to contribute equally to the capital and enjoy full
equality in exploiting the capital and sharing the profit or
not.Based on this consideration, sharikah can be divided into two
types, sharikah al mufawadah and sharikah al inan.
13
Sharikah al-aqd
Sharikah al mufawadah means an unlimited investment partnership,
whereby each partner must contribute equally to the capital, and
enjoys full and equal authority to transact with the partnership
capital or property.
14
Sharikah al-aqd
This type of sharikah clearly implies unlimited liability on the
part of partners since they are both agents and guarantors of each
other. Sharikah alinan can be defined as a limited investment
partnership.
15
Sharikah al-aqd
Whereby each partner may only transact with the partnership
capital according to the terms of the partnership agreement and to
the extent of the joint capital. Hence, their liability towards
third parties is several but not joint. The liability of partners
in Sharikah Al`inan resembles that of modern-day limited liability
partnerships.
16
Sharikah al-aqd
Both Sharikah Al-Mufawadah and Sharikah Al`inan can occur in all
the three earlier types of sharikah, i.e., Sharikah Al Amwal
(monetory partnership), Sharikah Al A`mal (labour partnership) and
Sharikah Al Wujuh (reputation partnership).
17
Sharikah al-aqd
Sharikah Al Mufawadah is rarely opted for due to the higher
degree of responsibility and the practical difficulty to achieve
full equality between the partners in all aspects of the
partnership18
Mudarabah
means that one party provides capital and the other utilises it
for business purposes under the agreement that profit from the
business will be shared according to a specified proportion.19
Mudarabah - IntroductionMudaraba is a kind of partnership where
partner involve in business;Mudarabah is partnership between
persons in which one partner gives money to another for investing
in profitable avenues.The investor (fund provider/supplier) is
called Rabb-ul-Maal while the person who utilizes this fund (the
fund manager) is called Mudarib;Mudarib is exclusively responsible
for management of the business.20
Mudarabah - Introduction Mudarabah Capital:In principle, the
capital of Mudaraba should be provided in the form of cash.However,
it may be presented in the form of kind i.e. tangible assets which
will be valued as per mutual consent;The value (in cash) of the
assets will be the Mudaraba capital;21
Mudarabah - Introduction Mudarabah Capital:The Capital of
Mudaraba should be clearly known to the contracting parties and
defined in terms of quality and quantity in a clear manner;Debt
(receivable) can not be the capital of Mudarabah.22
Mudarabah - IntroductionMechanism of Profit and Loss
distribution:The contracting parties should stipulate in the
contract the profit shares (in defined terms) for each one;The
profit sharing ratio should be:Specific; andof the profit expected
to be earned by the venture;23
Mudarabah - IntroductionTherefore following method is not
allowed:Unknown ratio;A ratio attributed to future settlement;A
ration linked with the capital (in terms of x% of the capital);A
lump sum settlement as profit;24
Mudarabah - IntroductionMechanism of Profit and Loss
distribution:Losses in Mudaraba shall only be born by Rabb-ul-Mal
and not by the Mudarib;Mudarib will also suffer loss in shape of
not receiving anything as profit;The Mudarib shall only be
responsible for losses if the loss happened due to his negligence
and willful misconduct.25
Mudarabah - TypesThere are two types of Mudarabah:Restricted
Mudarabah (Mudarabah Muqayyadah):It is a kind of Mudarabah in which
the capital provider restricts the Mudarib to perform business with
certain restrictions. These restrictions may be for place
(geographical restriction), particular type of investment (sector
wise restriction) or any other restriction provided these
restrictions do not unduly constrain the Mudarib from business
operations.26
Mudarabah - TypesUnrestricted Mudarabah (Mudarabah Mutlaqah):It
is a kind of Mudarabah in which the capital provider (Rabbul Maal)
does not put any restriction the Mudarib.27
Mudarabah - RulesSupply of funds:The basic feature of Mudaraba
is that the the capital is provided by Rabbul Maal and the Mudarib
is responsible for the management only;However, it is allowed for
Mudarib to add capital into the business of Mudaraba if agreed with
Mudarabi;In such cases Musharaka and Mudaraba are combined.28
Mudarabah - RulesFor example, Zuhaib gave to Rahman Hayder
Rs.100,000/- for Mudaraba. R. Hayder added Rs. 50,000/- from his
own with the consent of Zuhaib;This type of partnership will be
treated as a combination of Musharaka and Mudaraba;Here the Mudarib
may allocate for himself a certain percentage of profit on account
of his investment as Sharik, and at the same time he may allocate
another percentage for his management and work as a Mudarib. 29
Mudarabah - RulesTermination of Mudarabah:The contract can be
terminated at any time by either of the two parties after giving a
notice to the other party.If all assets are in form of cash and
some profit has been earned on the principle amount, it shall be
distributed between the parties according to the agreed ratio.If
the assets of the Mudaraba are in other form the Mudarib shall be
given an opportunity liquidate them and the actual profit may be
determined.30
MURABAHA
Murabaha is a particular kind of sale and not a financing in its
origin. Where the transaction is done on a cost plus profit basis
i.e. the seller discloses the cost to the buyer and adds a certain
profit to it to arrive at the final selling price.
31
Payment of Murabaha price may be:
1)At spot2)In installmentsIn lump sum after a certain time
Hence, Murabaha does not necessarily imply the concept of
deferred payment.
MURABAHA
32
Basic rules for Murabaha financing:Asset to be sold must
exist.Sale price should be determined.Sale must be
unconditional.Assets to be sold: a) Should not be used for
un-Islamic purpose.b) Should be in ownership of the seller at the
time of sale; physical or constructive.MURABAHA
33
Basic rules for Murabaha financing:
Re- negotiation of price and roll over of Murabaha are not
permitted.
Discounting of Murabaha instruments is not
permitted.MURABAHA
34
Step by step Murabaha Financing
Client appointed as agent to purchase goods on banks behalfBank
gives money to agent/supplier for purchase of goods.The agent takes
possession of goods on banks behalf.
35
Step by step Murabaha Financing
4. Client makes an offer to purchase the goods from bank through
a declaration.5. Bank accepts the offer and sale is concluded.6.
Client pays agreed price to bank according to an agreed schedule.
Usually on a deferred payment basis (Bai Muajjal)
36
Purchase of raw material; for meeting working capital needs of
trade and industry.Medium to long term requirements for purchase of
land, building and equipment.Trade finance products including
imports, exports and bill purchase.Applications of Murabaha
37
Accounting Treatment for Murabaha under IFAS-1
1- Payment to the customer for the purchase of goods on behalf
of bank or directly to the supplier(vendor) by the bank : Advance
against Murabaha Dr Customer A/C Cr
38
Accounting Treatment for Murabaha under IFAS-1
2- At the time of sale of goods to the customers with signing of
Declaration by the bank and the client: Murabaha Dr Murabaha Profit
Receivable Dr Advance against Murabaha Cr Deferred Murabaha Income
Cr 39
Accounting Treatment for Murabaha under IFAS-1
3- At the time of Booking of Accrual @ profit rate each month
the following entry would be passed*. [(amount x Profit rate) x 30
/ 365] Deferred Murabaha Income Dr Murabaha Income Cr
*this entry will be passed at the end of each month till
maturity.40
Accounting Treatment for Murabaha under IFAS-1
4- On Maturity of Murabaha transaction and at the time of
receiving of final payment following entry would be passed:
Customer A/C Dr Murabaha Cr Murabaha Profit Receivable Cr 41
Literally, it means To give something on rentIjarah is an
Islamic alternative of Leasing.Leasing backed by an acceptable
contract is an acceptable transaction under Shariah.
IJARAH
The question of whether or not the transaction of leasing is
Shariah compliant depends on the terms and conditions of the
contract. Several characteristics of conventional agreements may
not conform to Shariah thus making the transaction un-Islamic and
thereby invoking a prohibition.
IJARAH
Risk and rewards of ownership lies with the owner i.e. any loss
to the asset beyond the control of the lessee should be borne by
the Lessor. Late payment penalty cannot be charged to the income of
the Lessor. Lease and Sale agreement should be separate and non
contingent.IJARAH - Key Difference
44
The customer approaches the Bank with the request for financing
and enters into a promise to lease agreement.The Bank purchases the
item required for leasing and receives title of ownership from the
vendorThe Bank makes payment to the vendor
IJARAH - Process
45IJARAH AND IJARAH MUNTAHIA BITTAMLEEKThe customer approaches
the Bank with the request for financingThe client approaches the
Bank showing interest in purchase of the commodity. He will present
full description and detailed specification including the source of
supply.
The Bank will run a credit valuation, the same way its done in
conventional banking.
If the customer is a good risk, then the ` margin (i.e. Banks
profit on the market-up price) for him will have to be decided. The
margin will be quoted, most probably as a per annum flat rate based
on the total cost of acquiring the commodity by the Bank including
the price and all related expenses.
If the customer agrees, he will be asked to sign a pledge
agreement, committing him to buy such commodity once it is under
the possession of the Bank. As part of the Murabaha transaction,
the client will asked to present some securities to the Bank at the
time of signing the pledge. These securities could be in the form
of cash or any other liquid asset, equivalent to about 5% to 10% of
the value of the deal.
The Bank purchases the item and makes payment to the vendorThe
Bank will contact the vendor of the commodity specified by the
customer and make arrangements for the acquisition. The Bank will
make the required payment to the vendor for receipt of the
commodity.
The Bank receives title of ownership from the vendorThe Bank is
only able to execute the Murabah deal when the commoditys ownership
is completely transferred over to the Bank from the vendor.
The customer makes payment up-front or on a deferred basisThe
customer will either pay the Bank the whole amount of the Murabaha
contract (including a mark-up) up-front of make payments on a
deferred basis.
The Bank transfers the title over to the customer upon
paymentThe Bank will transfer the ownership title of the commodity
to the customer once the payment is received from the customer.
The Bank leases the asset to the customer after execution of
lease agreement.The customer makes periodic rental payments as per
the contractAt the end of the tenure customer can purchase the
asset from the bank with the help of separate Sale agreement.
IJARAH - Process
46IJARAH AND IJARAH MUNTAHIA BITTAMLEEKThe customer approaches
the Bank with the request for financingThe client approaches the
Bank showing interest in purchase of the commodity. He will present
full description and detailed specification including the source of
supply.
The Bank will run a credit valuation, the same way its done in
conventional banking.
If the customer is a good risk, then the ` margin (i.e. Banks
profit on the market-up price) for him will have to be decided. The
margin will be quoted, most probably as a per annum flat rate based
on the total cost of acquiring the commodity by the Bank including
the price and all related expenses.
If the customer agrees, he will be asked to sign a pledge
agreement, committing him to buy such commodity once it is under
the possession of the Bank. As part of the Murabaha transaction,
the client will asked to present some securities to the Bank at the
time of signing the pledge. These securities could be in the form
of cash or any other liquid asset, equivalent to about 5% to 10% of
the value of the deal.
The Bank purchases the item and makes payment to the vendorThe
Bank will contact the vendor of the commodity specified by the
customer and make arrangements for the acquisition. The Bank will
make the required payment to the vendor for receipt of the
commodity.
The Bank receives title of ownership from the vendorThe Bank is
only able to execute the Murabah deal when the commoditys ownership
is completely transferred over to the Bank from the vendor.
The customer makes payment up-front or on a deferred basisThe
customer will either pay the Bank the whole amount of the Murabaha
contract (including a mark-up) up-front of make payments on a
deferred basis.
The Bank transfers the title over to the customer upon
paymentThe Bank will transfer the ownership title of the commodity
to the customer once the payment is received from the customer.
Leasing is a contract where the owner of an asset transfers its
use to another person against an agreed price.However, ownership of
the leased asset remains with the Lessor
Rules of Ijarah
Since ownership of the leased asset remains with the Lessor, all
rights and liabilities relating to ownership are borne by the
Lessor. All rights and liabilities relating to use are borne by the
Lessee.
Rules of Ijarah
Subject matter of Lease should be Valuable, Identified and
Quantified.The period of Lease must be determined in clear
terms.The Lessee is responsible for damage to the asset caused by
fraud or negligence.
Rules of Ijarah
7. Any damage to the asset not caused by the Lessees neglect, is
to be borne by the Lessor.8. Normal maintenance is Lessees
responsibility.Rules of Ijarah
9. Lease rentals for the entire lease period must be fixed at
the time of Agreement; Different amounts of rents can be fixed for
different periods, but they must be known.The rent may be tied to a
known benchmark, acceptable to both parties.
Rules of Ijarah
10. The Lessor cannot increase the rent unilaterally11. The
Lessor may receive the rent in advance, but such payment should be
recorded as an Advance rental. Balance Sheet should reflect this
payment as Liability, since rent can be received only for use of an
asset.
Rules of Ijarah
The Lease period will start when the asset has been delivered to
the Lessee- in a usable condition- whether or not the Lessee has
started using itIf the leased asset is destroyed, the lease will
terminate.If the Lessee is at fault, he is liable to compensate the
Lessor for the lossRules of Ijarah
If the Lessee contravenes any term of the Lease agreement the
Lessor may unilaterally terminate the agreementIf there is no
contravention, the agreement can only be terminated by mutual
consentTermination of Ijarah
Accounting Treatment of Ijarah Transactions Rental Calculation
Rent = (asset cost paid by the bank x rate)/[1-(1/(1+rate)n)]
Rentals are to be recognized as income on accrual basis in a
systematic manner over the lease period, whereas carrying costs,
including depreciation, incurred in earning the Ijarah income are
recognized as an expense in the Income statement.
55
Accounting Treatment of Ijarah Transactions 1. At the time of
payment to the client for the purchase of asset on behalf of bank
or directly to the supplier by the bank Customer A/c Dr Security
Deposit Cr 2. When asset is delivered to Lessee Asset acquired for
Ijarah Dr Advance against Ijarah Cr
56
Accounting Treatment of Ijarah Transactions 3. Accrual of income
when it is due( Ijarah rentals are considered as income) Rental
Receivable Dr Rental Income Cr4. Recording of Depreciation expense
for Ijarah Asset Depreciation Expense Dr Accumulated Depreciation
Cr 57
Accounting Treatment of Ijarah Transactions 5. At the time of
receiving of Rental following entry would be passed: Customer A/C
Dr Ijarah Rental Receivable Cr 6. At the time of maturity of Ijarah
Contract Security Deposit DrCustomer A/C Cr 58
Salam (Forward Purchase)A salam transaction is the purchase of a
commodity for deferred delivery in exchange for immediate payment.
It is a type of sale in which the price, known as the salam
capital, is paid at the time of contracting while delivery of the
item to be sold, known as subject matter of salam, is deferred.
59
Salam (Forward Purchase)
Uses:Purchase of commodities (financing for production of
agricultural commodities/ minerals) Liquidity requirements of sugar
mills, etc.
60
Principles of SalamAn exception to the possession A contract
opposite to MurabahaPayment of full price at spot - otherwise
selling debt for debtAllowed in fungible commodities
61
Principles of SalamProduct of a particular origin can't be
specified Quality and quantity decided in unambiguous termsThe
commodity should remain in the market throughout the period of
contract (different opinions).
62
Principles of SalamThe time of delivery should be sufficient to
allow use of Salam capital conveniently A security/guarantee is
preferred as safeguard to the risk of defaultOnly commodity is
delivered and not the money
63
Parallel SalamThe disposal of commodity at the end of Bank can
be through:Parallel Salam: may sell commodity, before the date of
delivery, to some other purchaser for the date of original
delivery. The period in second contract will be shorter than the
original contract, but price will be higher than the original
contract.
64
Parallel SalamThe disposal of commodity at the end of Bank can
be through:
b. Unilateral Promise: Promise of purchase can be obtained from
third party for delivery on the date of original contract. Price in
this promise is set higher than parallel salam because the promisor
has to pay nothing.
65
Rules of Parallel Salam and Third Party PromiseBoth the
contracts i.e. Salam and parallel Salam must be independent of each
otherParallel Salam is allowed only with third parties The third
party giving unilateral promise should not pay the price in
advance.
66
Accounting Treatment 1. Entry, at the time of signing contract
and raising money to client as Salam Financing. Salam Financing Dr
Cash Cr 2. At the time of signing Parallel Slam with another
client.: Cash Dr Parallel Salam Financing Cr
67
Accounting Treatment 3. When goods are received from client-I
Salam Goods Dr Salam Financing Cr 4.Goods are given to client-II
(Parallel Salam) Parallel Salam Dr Salam Goods Cr Profit & Loss
A/C Cr
68
IstisnaIntroductionIstisna is a sale transaction where commodity
is transacted before it comes into existence.
DefinitionIt is an order to produc or to manufacture a specific
commodity for the purchaser.
69
Conditions of Istisnathe subject of Istisna is always a thing
which needs manufacturingManufacturer use his own material Quality
and Quantity should be agreed in absolute term Purchase price
should be fixed with mutual consent
70
Price of IstisnaPrice of Istisna may be spot and deferred
therefore Istisna is applicable where Salam is not applicable.Price
of Istisna can be paid in installments.The installments may be tied
up with different stages of manufacturing.
71
Right of RejectionWhen the required goods have been manufactured
by the manufacturer, purchaser can exercise his right to reject the
goods based on the defects in the manufactured goods
Revoking of IstisnaThe contract of Istisna can be cancelled
unilaterally before the manufacturer starts working.After starting
the work, Istisna cannot be cancelled unilaterally.
73
Accounting Treatment of Istisna Transaction1.Entry at the time
of disbursement of Istisna financing Istisna Financing Dr Customers
A/c Cr
74
Accounting Treatment of Istisna Transaction2. At the time of
receipt of Installment amount: Customers A/c Dr Istisna Financing
CrProfit Receivable Cr
75
