Question

IB Islamic Bank (IBIB) of Saudi Arabia entered into an Istisna' contract with the Government of Malaysia on 1st January 2014 for $100 million. IBIB is to construct a 4-storey-hospital to be completed and handed over to the Malaysia government on 31st December 2016.

 

IBIB and AZRB Corp

IBIB then entered into a parallel Istisna' contract with AZRB Corp for RM 80 million on 28th February 2014. The subcontract restricts any passing over to IBIB of any increase in costs up to an additional $20 million above the initial contract price. The agreement required billings by AZRB to IBIB at the end of each year to be paid promptly by IBIB on the 31st of January in the subsequent year. This was carried out as agreed.

During the second year the expected cost of the building went up by $30 million. However, in the third year the total cost was only $90 million and AZRB adjusted the final billing to reflect this.

 

The billings by AZRB to IBIB were as follows:

End of 2014               $30 million

End of 2015               $30 million

End of 2016               the balance

 

IBIB and the Malaysian Government

IBIB billed the Malaysian Government as follows:

Initial deposit                                                                            5%

End of Year 1                                                                             20%

End of Year 2                                                                             30%

End of Year 3 (when the building is handed over)                     45%

 

The Malaysian government paid in the same year except for the last progress payment. Due to budgetary constraints, the Malaysia government could not pay IBIB the payment in Year 3. It requested IBIB to defer payment over another 3 years in equal instalments. IBIB then proposed a Murabaha contract to sell the remaining part of the building with a mark-up of 10% per annum over 3 years to the Malaysian government and it was duly agreed. This government paid IBIB the yearly instalments equally over the 3 years starting from 31st December 2017.

 

 

IBIB's policy

 

Istisna' contracts: percentage of completion method

Murabah: profits recognized in proportion to instalments received

 

Required:

 

1. Calculate the profits/losses for the year 2014, 2015 and 2016 based on percentage of completion method
2. Calculate the cash equivalent value (CEV) for the years 2014 and 2015
3. Calculate the balance billed by UEM at the end of 2015
4. Prepare the extract of the Income Statement and Statement of Financial Position for and as at 31 December 2014 to December 2017
5. Prepare the journal entries for the Murabaha transactions
6. Would you prefer Bai Bithamam Ajil or Istisna' contract from an Islamic bank to finance an unfinished house? Why? Explain another Islamic contract that can be used to finance a house other than Murabaha where ultimate ownership is transferred to you

Answer 1

a.

Year 2014

 

	Dr ($)	Cr ($)
Istisna’ WIP	30 million
Istisna’ Account Payable (recognition of cost)		30 million
Cash	5 million
Istisna’ Billings (upon signing the contract)		5 million
Cash	20 million
Istisna’ Billings (receipts of billings)		20 million
Cost of Istisna’ Revenue	30 million
Istisna’ WIP	7.5 million (30*[100-80]/80)
Istisna’ Revenue (portion of revenue and profit recognized)		37.5 million

 

Year 2015

 

	Dr ($)	Cr ($)
Istisna’ Account Payable	30 million
Cash (payment of outstanding cost - 2014)		30 million
Istisna’ WIP	50 million
Istisna’ Account Payable (recognition of cost)		50 million
Cash	30 million
Istisna’ Billings (receipts of billings)		30 million
Cost of Istisna’ Revenue	30 million
Istisna’ WIP		7.5 million
Istisna’ Revenue (portion of revenue and loss recognized)		22.5 million

 

 

Year 2016

 

	Dr ($)	Cr ($)
Istisna’ Account Payable	60 million
Cash (payment of outstanding cost - 2015)		60 million
Istisna’ WIP	10 million
Istisna’ Account Payable (recognition of cost)		10 million
Cost of Istisna’ Revenue	10 million
Istisna’ WIP	10 million (100-80-10)
Istisna’ Revenue (portion of revenue and profit recognized)		20 million

 

b.

 

Cash Equivalent Value (CEV):

= 100 - (100 - 30 -50)

= 100 - 20

= 80

 

c.

 

Istisna’ WIP
		$			$
Year 2014	IAP	30 million	Year 2014	b/d	37.5 million
	Istisna’ revenue	7.5 million
Year 2015	c/d	37.5 million	Year 2015	CEV	80 million
	IAP	50 million		Istisna’ revenue	7.5 million
Year 2016	c/d	80 million	Year 2016	b/d	100 million
	IAP	10 million
	Istisna’ revenue	10 million

 

d.

 

 

Statement of Financial Position (extract) as at

	2014	2015	2016	2017
Istisna’ WIP	37.5 million	80 million	100 million	100 million
Less: Istisna’ billings	25 million	55 million	100 million	100 million
Less: loss recognized	-	-	-	-
Net Istisna’ WIP	32 million	25 million	-	-
Istisna’ account payable	30 million	50 million	10 million	-
Murabaha Financing	-	-	58.5 million	39 million
Less: unearned income	-	-	13.5 million	9 million
Net Murabaha financing	-	-	45 million	30 million

 

Income Statement (extract) for the year ended

	2014	2015	2016	2017
Istisna’ revenue	37.5 million	22.5 million	20 million	-
Less: COIR	30 million	30 million	10 million	-
	7.5 million	(7.5 million)	10 million	-
Murabaha income	-	-	-	4.5 million
Profit/(Loss)	7.5 million	(7.5 million)	10 million	4.5 million

 

e.

Year 2016

	Dr ($)	Cr ($)
Murabaha Financing	58.5 million
Istisna’ Billings		45 million
Unearned Murabaha Income (convert to Murabaha contract)		13.5 million

 

Year 2017

	Dr ($)	Cr ($)
Istisna’ Account Payable	10 million
Cash		10 million

 

Year 2017, 2018, 2019

	Dr ($)	Cr ($)
Cash	19.5 million
Murabaha Financing (receipts of Murabaha instalments)		19.5 million
Unearned Murabaha Income	4.5 million (10%*45)
Murabaha Income		4.5 million

 

f. 

Bai Bithamam Ajil or BBA means a deferred payment sale. Using this contract, the Islamic bank may finance the customer who wishes to acquire a given asset but  to defer the  payment of the asset for a specific  period or to pay by  instalment. The  assets  that  the customer  wishes to purchase for  example,  are  bought by the  bank  and  sold to the customer  at  an  agreed  price.  An  agreed  price  will include  the  bank's  mark-up  profit. However, it has proven to be quite unsatisfactory to the customers and bankers. Customers are particularly unhappy when  it  comes  to  early  redemption  or  in  the  event  of default  as  BBA  carries  a  higher  financing  balance  as compared  to  the  conventional  housing  loan.

Therefore, Istisna’ contract is more preferable to finance an unfinished house. According to Islamic perspective, Istisna’ is debt financing. For a buyer to buy a house is taking a risk in their financial process. Furthermore, they intend to buy houses under construction. The commission to manufacture contract is concluded through the offer and acceptance of the buyer and seller or manufacturer. Since the housings’ pricing is increasing every year. Buying a house under construction is a riskier to the customer and the contractor. Therefore, sales and purchase of non-existent or a house that is still under construction treated as gharar is revised under this contract.

Another Islamic contract that can be used to finance a house other than Murabaha where ultimate ownership is transferred to the customer is Musharakah Mutanaqisah (diminishing partnership). Musharakah  Mutanaqisah  or MM  contract combines two basic  Islamic concepts. First, the customer  enters into  a partnership  (musharakah)  under the concept of Shirkat al-milk (joint ownership) agreement with the bank. Secondly, the bank leases its share in the house  ownership  to  the  customer  under  the  concept  of Ijarah (leasing).  Under the MM contract, the customer pays a down payment as his equity share while the remaining balance is paid off by the bank. The bank leases the house so acquired to the customer and the bank receives rental from the customer in return. The customer and bank co-own the property with an initial pre-determined share of ownership. For example, the client owns 20 percent while the bank owns 80 percent of the property. The customer will gradually redeem the equity share of the bank through the financing period until the full amount is paid. The MM contract ends when the property is 100 percent owned by the customer and the ownership title is transferred to the customer.

 

Refer answer details for question a, b, c, d, e and f