Assoc. Prof. Dr.

Shahul Hameed Mohamed Ibrahim

T.A. Shamikh Khan
IE-1002: Reporting of Islamic Financial Transactions
Unit-7
Accounting for Sale based transactions-I : Murabaha &
Bai Bithaman Ajil






Introduction
Concept of sales
Murabaha & Murabaha To Purchase Orderer
Shariah Principles & Rules in Murabaha &
MTPO
Recognition & Journal Entries
Measurement of Murabaha Financing Assets
& Income Recognition
Problem Illustration






Contents
2
Introduction
Murabaha or cost plus mark up sale is the first of asset based
financing contracts employed by Islamic banks.
It is the most widely used financing instrument as it somehow
resembles a loan contract.
In this unit, we will first define murabaha, murabaha to the
purchase orderer.
Then we will discuss the rules and principles of the contracts
to understand what accounting entries are needed.
We will then learn the accounting entries on contract
initiation, instalment receipts, revenue recognition,
recognition and measurement of assets, and the
accounting treatments for termination, deposits and
penalties.
3
Concept of Sales
In Islam, Sale can take place in following 3 ways:

On the spot exchange, where the buyer gets the goods and
pays the price to the seller on the spot.
Sale for deferred payment (Bai al muajjal), where the
seller sells the goods but the pays the agreed price at a future
date in a full lump sum or in installments over a period.
The buyer pays in advance for an agreed kind, quality,
quantify of goods and the seller either makes it to order
(Istisna) or buys or produces it (Salam) and delivers it to the
buyer at a later agreed date.


4
Murabaha & Murabaha To The Purchase
Orderer (MTPO)
The bank buys the goods for murabaha sale from the vendor
and pays for it.
The Bank enters into a murabaha contract with a customer
and delivers the good.
The customers pay the bank in installments over the contract
period.

5

VENDOR ISLAMIC BANK
CUSTOMER
(1)
(3)

(2)
Murabaha transaction:
instalment
Murabaha contract
Continued
Some Islamic banks such as the Kuwait Finance House
practice this model, in the case of motor car financing.
The bank has warehouses, where it keeps its cars which it has
bought from manufacturers or dealers.
Customer goes to the warehouse and selects a car, informs
the bank & signs a murabaha contract. He drives off with the
car and pays for it later in instalments.
However, most Islamic banks do not want to do this, as it
involves trading and it is risky in the sense that the bank is an
owner of the bought goods and is thus liable for all risks
related to the goods.
Hence, in most cases, Islamic Banks use Murabaha to the
Purchase Orderer which is explained next.
6
Continued




7
Murabaha To The Purchase Orderer:

VENDOR
ISLAMIC BANK CUSTOMER
(2)


(1)

(3)

(4)

1. The customer orders the bank to purchase the identified
goods, which it promises (this may be binding or non
binding) to buy from the bank giving it some profit.
2. The bank buys and pays for the goods from the vendor.
3. The bank executes a Murabaha contract of sale to the
customer and delivers the goods.
4. The customer pays for the goods on an installment basis to
the bank.

Continued
A Murabaha is defined by Fuqaha (jurists) as the sale of goods
at cost plus an agreed profit mark up .Its characteristic is that
the seller should inform the purchaser of the price at which
he purchased the product and stipulate an amount of profit
in addition to this.
We can redefine Murabaha as a sale in which the Islamic bank
informs the customer of its own cost and the profit it is taking
on the transaction and where the sale price is paid in
instalments over an agreed period of time.


8
Shariah Principles & Rules in Murabaha
& MTPO
In a Murabaha to the purchase orderer, the promise of the
orderer to buy the goods from the orderer may be binding
or non-binding.
One group of Scholars view that the promise is non-binding
because:
The bank cannot sell what it does not possess (at the time of making
the promise)
The goods may be defective, deficient or unnecessary when delivered.
However, this will present problems to the Islamic banks as it
incurs cost to purchase the goods and as a financing
institution would not want to be left with unsold inventory.

9
Continued
In order to reduce the risk of the Islamic bank, the bank may
require a deposit from the Orderer (potential customer) to
ensure his seriousness.
Under the Sharia, there are two types of deposits which the
bank can demand:
Hamish Jiddiyyah (Refundable): It is the amount paid by the purchase orderer
upon request of the purchaser to make sure that the orderer is serious in his
order of the asset. However, if the promise is binding and the purchase
orderer declines to purchase the asset, the actual loss incurred to the
purchaser shall be made good from this amount.
Urboun (Non-Refundable): It is the amount paid by the client (orderer) to the
seller (i.e., the original purchaser) when the former purchases an asset from
the seller. If the customer proceeds with the sale and takes the asset, then the
urboun will be part of the price; otherwise, the urboun will be forfeited by
the seller.



10
Continued
In the case of late payment and procrastination by the
customer, the bank normally cannot levy any penalty as this
would amount to interest.
If the sharia board agrees on a penalty, then this penalty
cannot be recognized as revenue but given away as charity.
The Islamic bank can institute legal proceedings to recover the
debt and financial damage caused by procrastination (e.g. legal
fees, lost opportunity).
If the indebted owner is insolvent and fails to settle the debt,
the bank should defer collection until he becomes solvent.
Due to competitive pressures, the Islamic banks may give a
discount for early settlement. This is allowed under the Sharia
and is called Ibra.

11
Recognition & Journal Entries
12

Order
Purchase
Financing
Deposit Disbursement
Receivable /
collateral
Cash / cash
equivalent
Gain/Loss on
disposal/deposit
refund

Refusal
Early
payment/default
Installment
repayment
Rebate/Write
-off
Transaction flow and accounting event:
No. Transactions /Events DR
CR.

1
Purchase of Asset by
Bank
Equipment Cash/Creditors

2 Murabaha sale
Murabaha Financing (cost +profit) Equipment at cost and
Deferred profit or unearned income
with profit

3 Installment receipt
Cash Murabaha Financing

4
Recognition of profit as
each installments
received
Deferred profit Profit and Loss

5. Termination of contract A/c Receivable Murabaha Financing

6 Rebate for early payment Deferred Profit Murabaha Financing



In Murabaha, be careful to deduct the security deposit either Hamish Jiddiyah or Urboun from
the cost of the equipment or house before calculating the mark up. The mark up is on the
financing given to the customer, not the on cost of the equipment being financed.

Recognition & Journal Entries
13
14
EG:
1. Dentist requires financing for dental chair costing RM100,000
2. Bank finances using Murabaha with deferred payment over 5 years.
3. Profit mark-up 10% = RM10,000
Accounting:
1. Bank purchases dental chair
2. Bank structures murabaha financing
3. Customer pays first instalment
Need:
1. Structure of the financing

2. Annual repayment amount

3. Deferred revenue amount
Cost + profit = RM110,000
= RM110,000/5 years = RM22,000
= profit component = RM10,000
Dr Murabaha equipment RM100,000
Cr Bank RM100,000
Dr Murabaha financing RM110,000
Cr Murabaha equipment RM100,000
Cr Unearned income RM 10,000
Dr Bank RM22,000
Cr Murabaha financing RM22,000
4. Revenue recognition
Dr Unearned Revenue RM2,000
Cr Revenue Earned RM22,000
15
Financial statement disclosure (components):

Murabaha financing (gross) RM88,000
Unearned revenue RM8,000

Murabaha financing (net) RM80,000
Notes to account (see BISB)
2012 note 5 and note 21
Balance Sheet
15
Accounting:
1. Bank purchases dental chair
2. Bank structures murabaha financing
3. Customer pays first instalment
Dr Murabaha equipment RM100,000
Cr Bank RM100,000
Dr Murabaha financing RM110,000
Cr Murabaha equipment RM100,000
Cr Unearned income RM 10,000
Dr Bank RM22,000
Cr Murabaha financing RM22,000
4. Revenue recognition
Dr Unearned Revenue RM2,000
Cr Revenue Earned RM22,000
16
financing 100,000.00
profit 20,000.00
period 5 years
1 2 3 4 5 IRR
(100,000.00) 22,000.00 22,000.00 22,000.00 22,000.00 22,000.00 3.2635% 110,000.03
PV @ IRR 21,304.72 20,631.42 19,979.39 19,347.97 18,736.50 100,000.00
interest 695.28 1,368.58 2,020.61 2,652.03 3,263.50 10,000.00
islamic conventional islamic conventional
principal at risk
1 100,000.00 100,000.00 2,000.00 3,263.50 3,263.50
2 80,000.00 81,263.50 2,000.00 2,652.03 2,652.03
3 60,000.00 61,915.53 2,000.00 2,020.61 2,020.61
4 40,000.00 41,936.14 2,000.00 1,368.58 1,368.58
5 20,000.00 21,304.72 2,000.00 695.28 695.28
10,000.00 10,000.00
Balance Sheet Profit & Loss
Analysis
Up to this point, Islamic
accounting understates
conventional and thereafter,
it overstates.
Reason: discounting effect
Islamic accounting understates asset in the balance sheet
Measurement of Murabaha Financing
Assets & Income Recognition
Upon acquisition of Assets:
With obligation : Assets should be measured at lower of
historical cost or impaired value. (applying the prudence
concept of accounting & protect the purchaser)
Without Obligation: Assets should be measured at cash
equivalent value. (reflect current value & protect the bank/
financier)
A provision should reflect any decline between the acquisition
cost and cash equivalent value.
Price discount if obtained after acquisition should not be
treated as revenue but to reduce the cost of the relevant
goods unless agreed by SSB.

17
Continued
Upon financing the customer:
Murabaha receivables should be recorded (by the bank) at
face value (cash equivalent value) less provision for doubtful
debts.
Income recognition of Murabaha financing assets:
Profits are recognized at time of contracting for cash or credit
transaction not exceeding the current financial period.
If credit period > one financial period with a single or several
installment , the recognition methods are:
Accrual basis method
Cash basis method (????)

18
Continued
Accrual basis method recognizes profit based on a
proportionate allocation of profits whether cash is received or
otherwise
Cash basis method recognizes profit as and when the
installments are received and requires the approval of SSB
Principle of matching expenses with income is applied
Deferral profits (unearned) shall be offset against Murabaha
receivables in the statement of financial position.
Settlement amount is based on outstanding financial amount
(accrual basis)


19
Problem Illustration (BBA Financing)
20
Bank Syariah Berhad provides a financing facility based on Bai Bithaman Ajil (BBA)
principles to Ahmad bin Ali for the purpose of house purchase. The financing is
amounting to RM300,000 at a constant rate of return 8% for a period of 5 years. At the
end of the contract, Ahmad owes the bank a balance amounting to RM32,000. As part
of the normal requirements, the customers will be charged a penalty fee of 3% of the
outstanding amount due at the end of the contract and the amount collected is
normally disbursed as charity. The Bank recognizes income as instalments become due
and evenly over the period of the contract.

You are required to :

1. Prepare an extract of the balance sheet and income statement of Bank Syariah
Berhad from the beginning till the end of the contract to show the amount of net
receivable and Murabaha (BBA) income.

2. Prepare journal entries to record all the above transactions in the book of Bank
Syariah Berhad (including the treatment for penalty fee).
Solution (Extract of Balance Sheet)
21
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
BBA
Financing
420,000 336,000
(420 - 84)
252,000
(336-84)
168,000

84,000 0
Unearned
Income
120,000 96,000
(120- 24 )
72,000
(96-24)
48,000 24,000 0
300,000 240,000 180,000 120,000 60,000 0
Working: Sale price = 300,000+markup[ (8%x5x300,000)120,000]=420,000
Income earned Year 1 Year 5 = (120,000/5) 24,000 per year
Installment payable per year =420,000/5=84,000 per year
1.
Solution (Journal Entries)
22
2.
Year 0 Dr. BBA Fin 420,000
Cr. Cash 300,000
Cr. Unearned Income 120,000
( Recognition of BBA fin. )
Year 1 Dr. Cash 84,000
Cr. BBA Fin 84,000
( Repayment by customer )
Dr. Unearned income 24,000
Cr. Profit and loss 24,000
(Recognition of income )
Note : The same transactions for year 2 year 4
Continued
23
Year 5 Dr. Accounts Receivable 32,000
Dr. Cash 52,000
Cr. BBA Fin 84,000
Dr. Unearned income 24,000
Cr. Profit and loss 24,000
( Recognition of income )
Dr. Account Receivable 960
(Penalty BBA)
Cr. Charity payable 960
Note: when outstanding balance is received:
Dr. Cash 32,960
Cr. Account Receivable 32,960
Dr. Charity Payable 960
Cr. Cash (paid to charity) 960
Profit is recognized even
though loan remains
outstanding - Provided this
is not a bad loan
Amount outstanding
deemed paid and
transferred to normal
receivable.
24
financing amount 300,000
rate (constant) 8.0%
period 5 years
amount owing 32,000 at end of 5 years
penalty at end of contract 3.0%
A. calculate asset cost B. calculate profit, receivable & instalment
cost 300,000 300,000
profit 120,000
total value of asset 300,000 420,000
instalment 84,000
annual profit 24,000
C. instalment and accounting entries
BBA financing
BBA Asset bank receivable revenue unearned rev
purchase of house 300,000 (300,000)
BBA contract (300,000) 420,000 (120,000)
Start of year instalment by cust
year 1 84,000 84,000 (84,000) (24,000) 24,000
year 2 84,000 84,000 (84,000) (24,000) 24,000
year 3 84,000 84,000 (84,000) (24,000) 24,000
year 4 84,000 84,000 (84,000) (24,000) 24,000
year 5 84,000 84,000 (84,000) (24,000) 24,000
420,000 420,000 (420,000) (120,000) 120,000
net movement - 120,000 - (120,000) -
D. outstanding balance and penalty
amount outst 32,000 52,000
penalty 5% 960 goes to charity
total to be received 32,960
repayment by customer
1 Dr BBA Asset 300,000
Cr Bank 300,000
unearned rev (purchase of BBA Asset)
2 Dr BBA Receivable 420,000
CR unearned revenue 120,000
Cr BBA Asset 300,000
(record receivable under BBA contract with 8% return)
3 Dr bank 84,000
cr BBA Receivable 84,000
(instalment received)
4 Dr unearned revenue 24,000
Cr BBA revenue 24,000
(annual profit recognition)
5 Dr bank 52,000
Dr Receivable 32,000
Cr BBA Receivable 84,000
(instalment partially received and termination of BBA contract)
6 Dr receivable 960
Cr charity payable 960
25
1 Dr BBA Asset 300,000
Cr Bank 300,000
unearned rev (purchase of BBA Asset)
2 Dr BBA Receivable 420,000
CR unearned revenue 120,000
Cr BBA Asset 300,000
(record receivable under BBA contract with 8% return)
3 Dr bank 84,000
cr BBA Receivable 84,000
(instalment received)
4 Dr unearned revenue 24,000
Cr BBA revenue 24,000
(annual profit recognition)
5 Dr bank 52,000
Dr Receivable 32,000
Cr BBA Receivable 84,000
(instalment partially received and termination of BBA contract)
6 Dr receivable 960
Cr charity payable 960
At time of
contract
Year 1 to year
5
Year 5
26
0 1 2 3 4 5
PV factor 1.08 1.1664 1.259712 1.36048896 1.469328077
annual repayment amount RM75,136.94
repayment amount 375,685 75,137 75,137 75,137 75,137 75,137
PV of repayment 300,000 69,571 64,418 59,646 55,228 51,137
interest component 75,685 5,566 10,719 15,491 19,909 24,000
PV of balance of payments 230,429 166,011 106,365 51,137 0
principal repaid

interest 75,685 24,000 19,909 15,491 10,719 5,566
principal 300,000 51,137 55,228 59,646 64,418 69,571
balance of principal 248,863 193,635 133,989 69,571 0
(
(
(
(

=
i
i
A PV
n
) 1 (
1
1
year 1st for 300,000 * 8%
Principal * i interest
=
=
Conventional accounting
at drawdown Dr loans receivable 300000
Cr Cash 300000
(Being loans drawdown)
1st payment Dr Cash 75,137
Cr loans receivable 51,137
Cr interest income 24,000
2nd payment Dr Cash 75,137
Cr loans receivable 55,228
Cr interest income 19,909
P&L
Islamic RM120K (8% on RM300K) simple ROR
Conventional RM75,685 (reducing balance)

Balance Sheet
Islamic RM420K recognition upfront
Conventional RM300K at PV
(total repayment RM420,000 Vs RM375,685)
Effective yield
Islamic = 12.38% (equivalent to IRR); or
Conventional simple interest = 15137/300K=5.05%
Murabaha contract
We use the 8% return as the discount rate to find the
annual repayment of $75,136
27
How do we calculate the repayment under the discounting
model?
1. PV = $300,000; i= 8%, n = 5 years.
2. Using the i in (1) above, find the 5- yearly repayment of the
PV of $300,000.

(
(
(
(

=
i
i
A PV
n
) 1 (
1
1
08 .
) 08 . 1 (
1
1
000 , 300
) 1 (
1
1
000 , 300
5

=
(
(
(
(

X
i
i
n
(1.08)^5 1.469328077
1/(1.08)^5 0.680583197
1-[1/(1.08)^5] 0.319416803
{1-[1/(1.08)^5]}/.08 3.992710037
A 75,137
3. Split interest and principal components
from monthly repayment of $75,137
Year 1 principal repayment = $75,136-
$24,000 = $51,136
Yr 1 interest = $300,000 * 8% = $24,000
Yr 2 interest = $300,000 - $51,136) * 8% = $19,909
And so on ..
Note: this is for comparative purpose only. It is for those who are interested.
It is not intended that this is part of the core learning for this module.