Murabahah - the Accounting Measurement in Islamic Banks - Research Paper Example

The Accounting Measurement “Murabahah” in Islamic Banks Islamic finance has emerged in recent decades as one interesting trend in the financial world. It derives its principles from the Shariah, which, in turn, is based on the Quraan and Sunnah. Since the most important principle in Islamic finance is the prohibition of usury, Muslims have tried to develop some solutions to comply the Shariah with their financial needs. Islamic banks are one of the most important tools in Islamic finance. Serving a total population of more than a billion Muslims worldwide, it`s a serious business for Muslims. They have always tried to avoid any investment seen as contrary to the Shariah, such as interest-based loans or investments in alcohol, gambling, tobacco, pork products and sensual entertainment. Basically, there are five modes of financing that are commonly used by Islamic banks world-wide: Musharaka, Mudaraba, Murabaha, Ijara and Qard Hassan. Among them, Murabaha has represented the most popular instrument of financing in Islamic banks in Arabian countries. The legitimacy of Musharakah is based on a citation of the Quraan, where Allah says, "Allah has permitted trading and forbidden Riba (Usury)" (Al-Baqarah, verse 2: 275). Murabaha is defined as the sale of goods at cost plus an agreed profit mark-up (AAOIFI, 2003). Under a Murabaha transaction the Bank provides the customer with the money needed to purchase an asset for personal or business use. The asset could be purchased domestically or abroad. The customer, in coordination with the bank, negotiates the purchase price with the seller. The bank purchases the good(s) and resells it (them) to the customer, after adding an agreed profit amount and allowing the customer the convenience of paying the full amount over a period of time in installments. In traditional banking, the customer would likely incur fees or interest calculations if there is a default. But with Murabaha, the customer is only liable for the contracted good. If the actual cost can not be identified, then the Murabaha deal isn`t possible. Murabaha (credit sales) has been approved by the conferences of Islamic research centers as a legitimate method of selling and financing. The Murabaha sales are known as “trust sales”, which require that the original cost of goods or services is to be known to both the seller (KFH) and the buyer (the client). The Murabaha is, in theory, a form of trade financing. It’s not considered as a type of loan, but a deal (Bai).However, it is mostly practiced currently as an agreement between a final buyer and a middleman (a trader). The final buyer uses the services of the middleman because he can not or does not find the object himself, or because the middleman can obtain the object on better conditions, or purely as a financing tool (Schaik, 2001). An Islamic bank is in most cases used as an intermediate for financing. In such a case, a customer requests the bank to purchase the selected goods according to certain specifications. The bank purchases the goods, and resells them to the customer at the cost plus a certain profit. The Murabaha contract in such a case is called "Murabaha to the Purchase Orderer" (Suleiman, 2000). Most of the Murabahah financing works as follows: a) There is a promise/agreement between the bank and its client. This binds the client to purchase thing(s) in question from the bank, creates a financing facility in the name of the client, and authorizes the client to directly purchase from the suppliers (though at the behest of the bank) b) The client makes necessary purchase(s), and payment advices are sent to the bank, which will honor them. c) The client directly takes delivery of the good(s) from the supplier. d) Once the thing(s) is (are) with the client, a sale-purchase agreement is made between the bank and the client as follows. The client offers to buy (what is already with him) and the bank agrees to sell the same thing. e) The client discharges his payment obligations to the bank. f) The above process is materially no different from that associated with Supplier`s Credit, currently in vogue in interest-based banking. In case of separate Murabahah department: An example of a financial institution that holds an independent department for Murabaha operations is the Kuwait Finance House. Trough its Murabahah department, it finances the buying of goods and products like: Cars (new or used) either from cars agencies or cars dealers or individuals, construction works and materials, house furniture, trading deals and projects, boats, machines and marine equipments, electric and electronic equipments, computer sets, maintenance and spare parts, vehicles can be delivered in Egypt, United Arab Emirates, Syria, Germany and United States of America, provided that buying and payment transactions should be finalized in Kuwait. A few examples of the services and facilities provided by the KFH Murabaha Department would be: The value of goods and works obtained by the customer may reach up a limit of 20 times his/ her salary or monthly income; and may be increased in accordance with the  guarantees submitted by the customer; Profits are not collected in advance; The credit could extend up to 60 monthly installments subject to the value of the goods or the required works; It is not always required to transfer the client’s salary to Kuwait Finance House. However, this depends on the circumstances of each transaction; The alternative is either to pay in cash, or to authorize us to deduct the installments due amounts from your accounts at other banks; High flexibility in the approval of the transactions for all clients’ categories, and the guarantor is not always required; Immediate approval of the transaction that fulfill all the credit terms For undertaking a Murabahah operation, the department requires a series of documents from the client: A quotation including the price & specifications of the goods; Civil ID card; Recent salary certificate; Bank statement of account. KFH demands its customers to not have any transactional contact with the sellers. All agreements with the suppliers should be completed by KFH. The bank needs to buy and own the requested goods or services from the suppliers first. The trading process of Murabaha within KFH, as stated in the Murabaha (Credit Sales) Department regulation, depends on two bases: “First, KFH buys and owns the goods completely from the suppliers, then sells those goods to the client with agreed profit margin. As such, it is a selling process.  This kind of trading is ordained by God: “Allah permits the trading and forbids the usury”, (Albaqarah Surah, 275, Al-Quran). Second, once the agreed total selling price is agreed upon, and the goods or services have been delivered to the buyer, the sale becomes final. I.e. The debt amount does not increase if the buyer fails to pay certain number of installments on time, nor does it decrease if the buyer pays the remaining amount of debt before maturity.” In case of no independent Murabahah department: Murabaha is capturing 60% to 90% of all financing in Islamic banks (Omar, 1987; Keble, 1988; Haron, 2000; Schaik, 2001; and AAOIFI, 2003). Still, it is believed to be practiced without standardised accounting measurement bases. The lack of accepted accounting measurement may have resulted from a combination of several factors: The modernity of Murabaha as a financial activity in Islamic banks. The variety of Murabaha methods, since it’s practiced in the forms of cash or credit, local or international. The difference between the end of the financial year of the bank and the end of the Murabaha transaction. Lacking the professional expertise of an organized independent department, there is no assurance of an accurate Murabaha activity. Such weaknesses can cause some significant accounting problems such as (Al-Naighee, 1983): * The difficulty of measuring the original cost of each Murabaha transaction, especially, if it is in credit. * The uncertainty in the accounting treatment in the following cases: The change in the exchange rate of currency. Breaking the contract. Murabaha Sale Price Murabaha sale price is composed of the original cost of goods plus an agreed profit mark-up. It is similar to the "Historical Cost" in conventional thought. The acquisition cost of the merchandise includes not only its purchase price but also the cost of getting it, meaning, for instance customs duties and other taxes on purchases, transport and loading charges, insurance, so on. In theory, the original cost of Murabaha goods must include their direct cost, which includes: Direct manufacturing costs, meaning any added value of the merchandis, which might increase its cost. It is worth noting that the Islamic banks do not currently deal with such costs, because they most probably sell the goods to their clients without any changes. Direct marketing costs, such as transportation, shipping, advertisement, packing costs and salesmen commission for such goods. Direct administration costs, like tax and custom duties for merchandise, telephone and fax costs directly related to the transaction, the registration costs for such merchandise (if it is car, flat, house or building) and the documentary credit cost related to the transaction. It has also been generally agreed that the personal expenses, the general administrative overheads and any losses related to the Murabaha goods or to the bank in general must not be added to the original cost of the Murabaha goods. So, the expenses not related to the merchandise, wages and salaries of workers in the bank or even in the Murabaha department, gas and electricity expenses, depreciations, penalties, compensations or damages the bank paid must not be included in the original cost of Murabaha transactions (Al-Kasani, part 5; Ibn Qudama, part 4; Shehatah, 1987a; AAOIFI, 2003). Concluding the above statements, the original cost of Murabaha goods equals: 1. The purchase price + the direct marketing costs + the direct administration costs (in the case of selling the goods without manufacturing) Or 2. The purchase price + the direct manufacturing costs + the direct administration costs + direct marketing costs (in the case of manufacturing) The Profit Mark-up is normally determined as a percentage of the original cost, agreed between the bank and its client. This is the reason why it`s different for each transaction and bank. Still, there are two dominant tendencies of determining the profit margin: 1) The first states that the profit margin should be calculated based on the total cost of Murabaha merchandise. As an example: If the purchase price of Murabaha goods was 10,000 pounds and the transportation, taxes and communication expenses were 3000 [pounds sterling], then the profit margin percentage should be: 13,000 [pounds sterling] x 20% = 2,600 [pounds sterling] So, the Murabaha sale price 15,600 [pounds sterling]. 2) The second states that the profit margin should be calculated based only on the purchase price plus the direct manufacturing costs. For instance: If the purchase price of Murabaha goods was 10,000 pounds and the transportation, taxes and communication expenses were 3000 [pounds sterling], then the profit margin percentage should be: 10,000 [pounds sterling] x 20% = 2,000 [pounds sterling] + transportation, taxes and communication expenses, 3000 [pounds sterling]. Conclusion: This study underlined that all Islamic banks prefer to use marked-up facilities rather than profit-loss sharing. Although the principles of commerce are clearly indicated by Sharia, they should be used only after profit- loss sharing principles. While Islamic banking has grown phenomenally by any standard of measure, this has only occurred on an intra-country basis. For international expansion to become a reality greater standardization will be a prerequisite. References: 1. Kuwait Finance House (2008), Annual Report, Kuwait. 2. Murabahah (Cost Plus). Qatar International Islamic Bank (QIIB), n.d. Web. 19 Nov. 2009. Read More