Alakhawayn University in Ifrane

Islamic banking
Fundaments
Financial Instruments of Islamic
Banking and Finance
MURABAHA

By :
Hind LEBDAOUI, Ph.D
Sources and Uses of Funds by Islamic
Banks

Sources of Funds
Two major sources
1. Transaction deposits: risk-free funds which do not
yield return e.g. current accounts based on the
wadi’ah concept
2. Investment deposits: profit-making but have risk of
capital loss, depending on amount invested by bank
 Sources and Uses of Funds by Islamic Banks

Other sources
1. Current Accounts: account opened by individuals, companies and firms
by depositing cash, cheques and/or bills (based on concept of wadi’ah)

2. Saving Account: funds deposited in saving account yield some returns

depending on bank financial results. Based on wadi’ah, mudarabah and
musharakah concepts

3. Investment Account: the most important source of funds for Islamic

banks; the customer and the bank enter into a joint-venture agreement,
based on mudarabah concept
 Sources and Uses of Funds by
Islamic Banks
Application of Funds
§ Islamic banks apply funds to raise profits in different ways

The main channels for the outflow of the funds include the:
§ musharakah
§ mudarabah
§ murabahah (cost-plus financing)
§ ijarah (lease)
§ istisna’ (manufacturing contract)
§ - bay salam
§ bay mu’ajjal (deferred sale contract) models
 Partnership Contracts in Islamic
Finance

Concept of Equity-Based Contract

§ The equity-based contracts generally involve some sort of partnership

§ Partnership contracts which have been transformed into financial

instruments are
- Mudarabah (trust financing)
- Musharakah (joint-venture partnership)
- Musharakah mutanaqisah (diminishing partnership)
Concept of Exchange-Based Contract

Exchange-based contracts in Islamic law have been

transformed into viable (debt financing) instruments:
- Murabahah (Mark-up)
- Istisna’ (Manufacture Sale)
- Salam (Forward Sale)
- Bay Dayn (Sale of Debt)
- Tawriq (Securitisation)
- Sarf (Sale of Currency)
- Tawarruq (Cash Financing)
- Bay Inah (Sale with immediate purchase)

Debt-based financing instruments: Financial instruments that create

debt-like relationships between parties
 Concept of Exchange-Based Contract

Murabahah (Mark-up)

§ Murabahah: cost-plus financing contract where a sale is made at a

specified profit margin
§ Establishes a form of mutual contract between two parties where they
agree to the mark-up
§ Murabahah is derived from the root word ribh which means profit, gain or a
legal addition
Concept of Exchange-Based Contract
Figure 3.1: A Typical Murabahah Contract
Concept of Exchange-Based Contract

Figure 3.2: An Overview of the Murabahah Contract

 Accounting for Murabahah Financing
Introduction
§ Murabahah financing is an asset based financing widely used for
house and motor vehicle financing by Islamic banks . It is the most
widely used financing instrument as it somehow resembles a loan
contract.
§ Bay’ Al-Murabahah (‫ )ﺑﯾﻊ اﻟﻣراﺑﺣﺔ‬is basically an arrangement where the
customers, who wishes to purchase certain goods or assets, requests
the bank to purchase the items and sell them to him at cost plus a
declared profit.
§ The Islamic bank determines the cost price of the commodity that it
bought, and sells it at a declared profit.
§ In simple terms, Murabahah is sale of goods at cost plus mark up where
the purchaser should be informed of the cost of goods or assets and the
profit amount.
 Murabaha conditions

§ The Murabaha conditions include the following:

A. The Islamic bank should make the cost or capital outlay known to the client.
B. The first contract should be valid.
C. The contract should be free of usury.
D. The Islamic bank should disclose any fault which occurs after the purchase and
should disclose all what is related to the fault.
E. The Islamic bank should disclose the terms applicable to the purchase price, for
example if the purchase was on credit.
F. If any of the conditions in (a), (d) or (e) is not met, the purchaser shall have
the option to:
1. proceed with the sale as it is;
2. have recourse to the seller for the discrepancy; or
3. cancel the contract.
Introduction: The simple Murabahah

§ The simple Murabahah is as follows:

Figure 1: Simple Murabahah Financing
Mark-up

Seller Buyer

Price = Cost + Pre-Determined Mark-Up

 Introduction: Murabahah to the Purchase Orderer

Figure 2: Murabahah to Purchase Orderer

Mark-up

Seller Buyer

Supplier/
Developer

Murabahah to the Purchase Orderer is where it involves three parties, namely, the
purchase orderer, the purchaser and the seller. It involves intermediary due to lack of
expertise or need for credit facility.
 Murabahah to the Purchase Order

1. The customer orders the bank to purchase 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 banks 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.
 MPO a bunch of contracts

§ Master contract: unilateral an agreement to buy

§ Agency contract: Buy the item and take prossession

§ Murabaha contract
 Murabahah to the Purchase Orderer

§ In a murabaha to the purchase orderer, the promise to buy of the customer

(the purchase orderer) may be binding or non binding. This result from
different shari’a opinions. One group of scholars view that the promise is non-
binding because:
1. The bank cannot sell what it does not possess (at the time of making the promise)
2. 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.
Murabahah to the Purchase Orderer

§ 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 shari’a, there are two
types of deposits which the bank can demand:-
1. Hamish jiddiyyah (security deposit)
2. Urboun (Deposit)
Murabahah to the Purchase Orderer

§ These two deposits are defined by FAS2 as follows:-

§ Hamish jiddiyyah
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
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 the seller’s.
 Murabahah to the Purchase Orderer

§ Hamish Jiddiyayah is problematic, because, in case of a non-

binding promise, the bank will have to return the deposit in full to
the potential customer, even if it subsequently incurs a loss in
selling the goods, which the original orderer had refused to
take delivery.

§ In case, the promise is binding and the customer declines, the

bank can deduct any losses and expenses it incurs on
transaction from the deposit and return the excess. If the loss is
greater than the deposit, the customer becomes liable for the
balance.
Murabahah to the Purchase Orderer

§ In order to make it safer for Islamic banks, it should make

the contract a binding promise and then require Hamish
Jiddiyah or Urboun.

§ Credit risk? i.e. payment default by customer. To mitigate

this, the bank may request for a guarantee from the
customer. The goods sold under murabaha can be a
collateral for the debt. In this case, however, the customer
cannot sell the goods until the debt is repaid to the bank.
 Murabahah to the Purchase Orderer

§ 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 shari’a board agree 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”).
§ Unless the goods sold are collateral, the goods cannot be
taken by the Islamic bank to settle outstanding debt.
 Murabahah to the Purchase Orderer

§ If the indebted owner is insolvent and fails to settle the debt,

the bank should defer collection until he becomes solvent.

§ If the bank gets a discount on the purchase price.

§ The last rule to consider is early settlement of the debt or a

lump sum payment before scheduled time. ( disount for early
paiment ? ‘ibra.)
 Bai’ Al Muajjal Or Bai’ Bithaman Ajil

§ Another related model of Murabahah financing .

§ It is basically a trade-deal in which the seller allows the buyer to
pay the price of a commodity at a future date in lump sump or
installments.
§ Bay’ al muajjal refers to a sale against deferred payment (either
in lump sump or instalments).
§ If the sale is to be paid by instalments then the specific term
used is bai’ bithaman ajil.
§ Bay’ al-muajjal need not have a reference to the profit margin
that the supplier may earn. Its essential element which
distinguishes it from a normal sale is the deferred payment.
Bai’ Al Muajjal Or Bai’ Bithaman Ajil

§ In addition, in case of default or delay of the payment by the

customer, the price can no longer be raised. If the customer
is in financial difficulty, more time should be given to him,
and another date be fixed for the payment of the balance of
the price.
 Bai’ Al Muajjal Or Bai’ Bithaman Ajil

§ In order to be accepted in shari’ah, bai’ al-Murabahah should ensure the

following matters:
1. The Islamic bank must actually hold and own the property before selling it to
the customer
2. The first sale and purchase transaction between the bank and the producer
of the commodity being a separate transaction altogether from the second
sale and purchase transaction between the bank and the customer.
 Bai’ Al Muajjal Or Bai’ Bithaman Ajil

3. The Islamic bank should give the option to the customer whether to buy or
refuse the goods upon seeing them, thus, it cannot enforce a binding
promissory purchase contract on the customer.
4. The Islamic bank should bear the risk in the trade, i.e. by being
responsible for the goods prior to its sale and actual delivery to the customer.
5. The Islamic bank should not take deposits in advance from the customer
because such deposits signify the obligation to buy the goods and they
also mean that the actual transaction takes place before the bank buys the
goods;
 Bai’ Al Muajjal Or Bai’ Bithaman Ajil

6. The cost price must be known by the purchaser at the time of the contract
(majlis al-‘aqad);
7. The profit over the cost price must be specified and known by both parties;
8. The cost price must be something that is quantifiable and substitutable;
9. The Murabahah must not involve any of ribawi items, payable by the same,
which, may result in the occurrence of riba in the excess amount over the
cost price. For instance, selling a kilogram of wheat for a kilogram of wheat
also, plus a profit, which turns this case to be a clear riba al fadl;
10. The vendor must have bought the item for the bay’ al Murabahah in a valid
sale and purchase contract.
Murabahah Financing – AAOIFI FAS 2
Recognition of Assets

§ AAOIFI FAS 2 provides that ownership of the purchased asset is

transferred to the buyer at the time of contracting. Thus, accounting
journal entries to recognize the asset (financing) and income (profit) are
as follows:
§ At the time of contracting (Recognition of BBA Financing asset):
Dr. Murabahah / BBA Financing Account (with the Cost + Profit )
Cr. Cash Account or Account Payable (with the Cost)
Cr. Unearned Financing Income Account (with the profit (mark-up))
§ When the installment is received:
Dr. Cash Account
Cr. Murabahah / BBA Financing Account (with the installment received )
Murabahah Financing –AAOIFI FAS 2

Recognition of Assets
§ When the installment is due but not yet received:
Dr. Receivable Account
Cr. Murabahah / BBA Financing Account (with the instalment due)
§ When income is due to be recognized (accrual basis):
Dr. Unearned Financing Income Account
Cr. Profit and Loss Account (with the Murabahah / BBA Income
due)
§ Note: Unearned income account is created to gradually and equally
recognise income throughout the contract period. Unearned income
account represents the total mark-up or profit to be received.
 Murabahah Financing –AAOIFI FAS 2

Measurement of Asset
§ AAOIFI FAS 2 considered two alternatives on this issue:
1. The first alternative was to measure the asset available for deferred
payment sale at their purchase price.
2. The other alternative was to measure those assets at their acquisition cost,
which is the purchase price plus any direct expenses associated with the
acquisition process.
§ AAOIFI preferred the second alternative, which capitalizes direct
expenses associated with the acquisition process.
 Murabahah Financing –AAOIFI FAS 2
Measurement of Asset

§ AAOIFI FAS 2 also considered two alternatives in the valuation of

assets available for deferred payment sale at the end of the financial
period:
1. The first alternative was to value the assets at their fair value.
2. The other alternative was to value the assets at their book value.
§ AAOIFI preferred the first alternative because these assets are treated
as investments rather than fixed assets. Accordingly, their
measurement at fair value should enable the institution to recognize
and measure any unrealized gains and losses arising from the
investment. This is in line with the alternative measurement attribute to
the cash equivalent value concept.
 Case study

§ ABC Islamic Bank provides a Murabaha of US$ 200,000 for a Commodity at

a constant rate of return of 10% for period of 5 Years and requires an annual
installment payment of 60,000.
Requirement
1. Prepare an extract of the Balance Sheet and income statement at the
beginning and end of Year 1.
2. Prepare journal entries to record all the above transactions in the book of
Bank.
Solution
§ Total Unearned income = (5 × 60,000) – 200,000 = $ 100,000
§ Income per year = $ 20,000
Balance sheet
Year 0 Year 1
Murabaha receivable (300,000) (240,000)
Unearned Murabaha income (100,000) (80,000)
Net receivable 200,000 160,000
Income statement
Murabaha Income 20,000
 Dr. Cr.
Commodity a/c 200,000
Cash/Creditor a/c 200,000
(Purchase of Commodity)
Murabaha Receivable 300,000
Commodity at cost 200,000
Deferred Murabaha Profit 100,000
At time of Murabaha Sales
Cash 60,000
Murabaha Receivable
60,000
Recognition of profit on each installment‘s received
Deferred Murabaha Income 20,000
Profit and Loss
20,000
 Murabahah Financing –AAOIFI FAS 2
Question One

§ Bank Shari’ah provides a financing facility based on Murabahah to the

Purchase Orderer principles to Ahmad Ali for the purpose of house
purchase.
§ The financing is amounting to N300,000 at a constant rate of return 8%
for a period of 5 years.
§ At the end of the contract, Ahmad owes the bank amounting to N32,000.
§ As part of the normal requirements, the customers will be charged a
penalty fee of 3% per annum for any outstanding amount due at the end
of the contract and the amount collected is normally disbursed as
charity.
Murabahah Financing –AAOIFI FAS 2
Question One

§ You are required to:

i. Prepare an extract of the balance sheet and income statement of
Bank Shari’ah from the beginning till the end of the contract to show
the amount of net receivable and Murabahah income.
ii. Prepare journal entries to record all the above transactions in the
book of Bank Shari’ah (including the treatment for penalty fee).
iii. Explain the shari’ah requirements on the policy of charging penalty
fee for default in repayment by customers.
iv. Explain the similarities and the differences between Murabahah to
the Purchase Orderer, and Bai’ Bithaman Ajil financing.
Question One: Suggested Solution
(i) Extract of Balance Sheet:

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

BBA (420,000-84,000) (336,000-84,000) (252,000-84,000)

Financing 420,000 336,000 252,000 168,000 84,000 0

(120,000-24,000) (96,000-24,000) (72,000-24,000)

Unearned
Income 120,000 96,000 72,000 48,000 24,000 0
Net
Balance 300,000 240,000 180,000 120,000 60,000 0
(1) 8% X 5 = 40% (2) 300,000 X 140% = N420,000 (3) 120,000/5 = N24,000 (4) 420,000/5 = N84,000
 (ii) Journal Entries

Year 0
Dr. Cr.
Dr. Murabahah Financing Account 420,000
Cr. Cash account 300,000
Cr. Unearned Income 120,000
(Recognition of Murabahah Financing)
 (ii) Journal Entries

Year 1 to Year 4
Dr. Cr.
Dr. Cash Account 84,000
Cr. Murabahah Financing Account 84,000
(Being repayment by customers)
Dr. Unearned Income Account 24,000
Cr. Profit and Loss Account 24,000
(Being recognition of income)
(ii) Journal Entries

Year 5
Dr. Cr.
Dr. Account Receivable 32,000
Dr. Cash account (84,000-32,000) 52,000
Cr. Murabahah Financing Account 84,000
Dr. Unearned Income Account 24,000
Cr. Profit and Loss Account 24,000
(Being recognition of income)
 (ii) Journal Entries

…..Year 5
Penalty = 3% x 32,000 x 1/12 = 80/month
Dr. Cr.
Dr. Account Receivable 960
Cr. Penalty (BBA) Account 960
(Being penalty charged)
Dr. Cash Account 960
Cr Account Receivable 960
(Being penalty paid by customer)
 (iii) Shari’ah requirements on penalty charges:

(iii) Shari’ah requirements on penalty charges:

A. Can be imposed only minimum amount e.g. only 1% per annum
on payment in arrears and cannot be compounded.
B. Maximum amount of penalty or ta’widh cannot exceed total
amount of the remainder’s balance.
C. Penalty obtained by the Bank or the financier may be earned
and distributed according to normal profit distribution policy or
distributed as charity.
iv) Similarities between Murabahah to Purchase Orderer and BBA
1. Both are trade financing (sale at mark-up)
2. Both involved 3 parties (bank, seller, buyer)

(i) Differences between Murabahah to Purchase Orderer and BBA

S/No Murabahah BBA
1. Obliged to disclose mark-up Disclosure of mark-up is not
obligatory
2. Sale plus mark-up – repayment Repayment is deferred (deferred
can be deferred or lump-sum payment sale)
3. Customer may opt not to Customer obliged to purchase
purchase (i.e. no obligation)
4. 2 contracts executed at 2 2 contracts executed at the same
different times – need to time – receivable is created.
recognize asset temporarily