FIN 6650 ACCOUNTING AND CONTROL OF ISLAMIC

FIN 6650 – ACCOUNTING AND CONTROL OF ISLAMIC FINANCIAL SYSTEMS GROUP MEMBERS : AHMAD SUKRI SAMSUDIN NAAIMAH AHMAD RADZI NORLIZA MOHAMMED ROZHAM ABDULLAH Evalua te Musha rakah Mutan aqisah (MM) as a viable alterna tive to BBA financi ng of houses in Malays

O U T L I N E PART A • Definition of MM and BBA • Mechanism • Legal Documentation • Computation PART B • Issues on MM • Comparison MM & BBA PART C • Implementation Of MM in other countries • Conclusion & Recommendation • Q&A

M U S H A R A K A H The term “Musharaka” is derived from the Islamic fiqh concept of “Shirkah” which means sharing or partnership. 1. Shirkat-ul-Milk: means joint ownership between two or more persons or parties in a particular property or asset. 2. Shirkat-ul-Aqd: means a contract between two or more persons or parties participating for a common business objective. The sole purpose is to share profits and losses arising from a jointly owned enterprise in accordance with the principles of Shariah. Source : First Pakistan Islamic Banking & Money Market Conference September 14 – 15, 2005.

E V I D E N C E Shariah Evidences Al-Quran (Surah An Nisa) 4: 12“They are partners in one third ” 38: 24 “ Many of the partners wrong one another, except those who believe and do good deeds…” Hadith “I (Allah) am a third party in a partnership of two so long as one of the partners does not betray the other. If however he does betray the other partner, I (Allah) will come out of the partnership”. (Narrated by Abu Hurairah)

Definition M U S H A R A K A H • Musharakah – A form of partnership between the Islamic bank and it clients whereby each party contributes to the capital of partnership in equal or varying degrees to establish a new project or share in an existing one, and whereby each of the parties becomes an owner of the capital on a permanent or declining basis and shall have his due share of profits. However, losses are shared in proportion to the contributed capital. It is not permissible to stipulate otherwise. • Diminishing Musharakah – It is a Musharakah in which the Islamic bank agrees to transfer gradually to the other partner its (Islamic bank’s) share in the Musharakah, so that the Islamic bank’s share declines and the other partner’s share increases until the latter becomes the sole proprietor of the venture. Source : App E – Definitions, AAOFII FAS No 4

Definition B B A • Basically a sale contract • Provides the buyer the benefit of a deferred payment • Deferred price of the sale object carries an additional profit • Extension of the murabahah (cost plus) contract whereby the commodity exchanged is “delivered” immediately but the sale price (with profit) is paid in instalments, over a specified period.

Financing Mode of BBA Developer 90% Balance Arbun (10%) Offer PSA Islamic Bank PPA Deeds Client

M E C H A N I S M 1. 2. 3. 4. 5. The customer approaches the Bank with the request for Home Financing The Bank enters into a Musharakah (Joint Ownership) agreement with the customer. Customer pays 10% as the initial share to co-own the house and Bank provides 90% share. Customer agrees to pay rental to Bank for the use of Bank’s share in the property. Customer’s share ratio would gradually increase after each rental payment due to the periodic redemption until fully owned by the customer.

D O C U M E N T A T I O N

Payment Schedule for Musharakah Mutanaqisah E X A M P L E

Accounting Treatment of Musharakah Financing A C C O U N T I N G • Recognition of the Islamic Bank’s share in Musharakah capital at the time of contracting • The Islamic bank’s share in Musharakah capital (cash or kind) shall be recognised when it is paid to the partner or made available to him on account of the Musharakah. This share shall be presented in the Islamic bank’s books under a Musharakah financing account with (name of client) and it shall be included in the financial statements under the heading “Musharakah Financing”. • Para 2, FAS 4 • MASBi-1 requires accrual basis.

Musharakah – Islamic Bank’s side A C C O U N T I N G • Recognition of Bank’s share at the time of disbursement / contracting: DR Musharakah Financing CR Cash • At the time of rental payment from customer : DR Cash CR Musharakah Financing • Being profit received from Musharakah Financing : DR Cash CR Profit & Loss (credit to P&L if profit and vice versa)

I S S U E S Ø PROPERTY Ø COST Ø CONTRACT Ø COLLATERAL Ø PRICING Ø DIVERSITY

P R O P E R T Y Property under Construction • How is it possible for the financier and the customer to enter into Ijarah agreement when the property is still under construction? • Does that mean that the lease can only takes place after the house is completed? • In the interim, is the customer required to service any kind of payment to the financier who has released the money progressively to the developer?

C O S T • Costs /Stamp Duty • MM transaction, involves various contracts such as Ijarah and Musharakah. • Problem of interpretation of the schedule of Stamp Act 1949.

Example: • • C O S T Item 4 – First Schedule (Stamp Act 1949) Agreement or Memorandum of Agreement made under hand only, and not otherwise specially charged with any duty, whether the same is only evidence of a contract or obligatory on the parties from its being a written instrument. – RM 10. 00 • Item 49 A - First Schedule (Stamp Act 1949) Lease or Agreement for lease under the principle of Al -Ijarah of the Shariah law for the purpose of financing or securing repayment of money. – The same ad valorem (A tax, duty, or fee which varies based on the value of the products, services, or property on which it is levied) duty upon a charge or mortgage for such total amount. – Financing Amount X 0. 5% Source : Stamp Act 1949

C O N T R A C T Ø It has been suggested by Sheikh Taqi Osmani that in order to make a mechanism of MM Shariah compliant, all contracts must be executed independently of each other and at a different date. Ø But, if the bank were to execute documents simultaneously, he emphasizes that such agreements should only be promises and not binding contracts. Ø If this is so, it will not help the development of MM, as no bank will enter into long term commitments to buy or build houses depending on non-binding contracts with its clients. Ø This position is even worst, if we take the extreme view of Sheik Sidiq Al-Darir, where he said that the buyer should be given the choice to decide when to buy and whether to buy or not.

C O L L A T E R A L • Can the property being the subject matter of the Musharakah be taken as collateral by the financier who owns undivided half shares in the property? • If no, what would be the recourse for the financier if the customer defaults?

P R I C I N G • Determination of Rental Rate ØBased on market rental value ØBy location ØRental value changes (mostly increasing trend) ØKeeping track of rentals in various locations

P R I C I N G • Determination of Rental Rate § Benchmark of market interest rate (e. g. LIBOR, BLR) – render Musharakah Mutanaqisah similar to conventional. § “It is always preferable not to use a benchmark normally used in interestbased transactions, so that an Islamic transaction may not have resemblance with an interest-based transaction. ” Quote : Shaikh Nizam Yacuby & Muhammad Taqi Usmani (1998 taqwa)

Interview with RHB Islamic Bank P R I C I N G Date : 5 April 2006 Venue: RHB Islamic Bank Corporate Office CEO - Mr Khalid M. Bhaimia Head of Products Development - En Jasani Bin Abdullah § In the case of property under construction, the Bank and the customer may enter into an Al. Istisna’ agreement prior to Musharakah. § Benchmark is not decided yet but could use COF / BLR + spread but not market rental rate. § Because the House Price Index is not adequately established at the moment. § Other information remains highly confidential and we were not able to analyze further on the pricing mechanism that will be implemented.

D I V E R S I T Y • Diversity of literature • Different banks may have different approach in its implementation & documentation • Examples: • HSBC Trust Company who will hold ownership of property on trust for both bank & customer. Source : (1) First Pakistan Islamic Banking & Money Market Conference September 14 – 15, 2005 (2) www. hsbcamanah. com

C O M P A R I S O N • MM Contracts musharakah where the client is a partner and the second one is an ijarah which involves the leasing of the property. • BBA Follows the murabahah concept of buying (PPA) and selling (PSA) of property.

C O M P A R I S O N • MM Value of the house under MM always reflects the market price and the rental is determined by the market rental values. • BBA The selling price of the house does not reflect the market value since the markup for the deferred payment is quite substantial.

C O M P A R I S O N • MM Rate of return is determined by rental rate based on the market rental value. • BBA The return to the BBA is based on a fixed profit rate (that uses the prevailing interest rate as the benchmark).

C O M P A R I S O N • MM The balance can never be larger than the original price/finance of the house. [Refer to sample of calculation] • BBA Rebates for early redemption under BBA cannot be specifically stated in the contract. At the sole discretion of the Bank.

E X A M P L E

C O M P A R I S O N • MM Yet to be implemented in Malaysia but theoretically viable / feasible. Example : RHB Islamic Bank is in the process of launching MM. • BBA Currently many customers opine that the BBA is similar to the conventional loan with some “disadvantages” for the customer particularly for early redemptions.

C O M P A R I S O N • MM Accepted internationally as Shari’ahcompliant. • BBA Recognized predominantly in the South East Asia, i. e. in Malaysia, Indonesia, Brunei etc. “…Back door for dealing on the basis of interest” – Council of Islamic Ideology (Pakistan)

I M P L E M E N T A T I O N Musharakah Mutanaqisah implementation worldwide

C O N C L U S I O N • Well accepted worldwide & implemented– E. g. Middle East Shariah scholars disapprove BBA dominant in South East Asia region. • Alternative to BBA – it promotes the migration from debt based financing to equity based financing. E. g. Affin Bank case Civil Appeal No D 4 -22 A-67 -2005 • Maqasid Shariah – favorable to the customer e. g. early settlement.

R E C O M M E N D A T I O N Ø A well-defined, adequately qualified and staffed, organizational structure. Ø A Software will be in place to ensure proper accounting and GL maintenance Ø Islamic Bank will undertake a Shariah compliance review at least annually, performed by Shariah Advisory Board or external audit function, having required knowledge and expertise. Ø Amend Legal Framework e. g. Stamp Act. Ø BAFIA – Ownership issue especially for commercial banks with Islamic windows. Ø Benchmark to House Price Index NOT interest Proper maintenance of HPI / Rental value in Malaysia is urgently required.

• • R E F E R E N C E • • • • Financial Accounting Standard 4 Ahamed Kameel Mydin Meera & Dzuljastri Abdul Razak. “Islamic Home Financing through Musharakah Mutanaqisah and Al-Bay’ Bithaman Ajil Contracts : A Comparative Analysis” (Unpublished). Dr. Abdin Salama (2002). “ Housing Finance via Islamic Methods” New Horizon, November 2002 Ramadhan 1423. Stamp Act 1949 Asma Siddiqi (2000), “Anthology of Islamic Banking”, Institute of Islamic Banking and Insurance London (1 st Edition) Muhammad Anwar (2000), “Islamicity of Banking and modes of Islamic Banking”, Research Centre, IIUM (1 st Edition) Ataul Huq Pramanik (2006), “Islamic Banking How Far Have We Gone”, Research Centre, IIUM (1 st Edition) Websites http: //media. live. harnesslink. com/files/f 1142718603. doc http: //www. witness-pioneer. org/vil/Books/MG_CIBF/chapter_2. htm http: //www. cljlaw. com www. hsbcamanah. com www. ubk-plc. com www. lariba. com www. arabbanking. com

T H A N K Y O U . . ALLAH KNOWS BEST. . Q & A