Islamic Financing Forms

1. Islamic Financing Forms As Applied by Islamic Banks

2. Dr. Hussein shehata Prof. of accounting Al- Azhar University Cairo

3. Preface Moslems-certainly – believe that Islam is a way of life, it is a Belief, Jurisprudence, a State and a Whole System. Allah said: "We have neglected nothing in the Book" (al- Annam 38) . Islamic jurisprudence (Islamic Law) is universal, perfect, permanent for all times and places, and comprehensive for all things and affairs . The Islamic Economic System is a sub-system of the whole Islamic Economic system. It is ruled by the Islamic jurisprudence . Teachings and Principles . (أحكام ومبادئ الشريعة الإسلامية )

4. One of the main purpose of Islamic Banks is to collect funds according to Mudaraba Contract, and invest these according to Islamic financing forms . This book is mainly concerned with Islamic financing forms, Nature, principles , and how they are applied in real life by Islamic Banks. Some case studies will be introduced to familiarize the reader with their practical side .

5. Our approach in compiling this book is as follows : • A brief overview on the nature and the principles of each Islamic financing form. • The main procedures as carried out by Islamic Banks . • Case studies on each Islamic financing form through figures .

6. I have done my best to make the selected Islamic financing forms in this book very easy to follow and to be applied in real life, so as to be of great help for Banks, Business-men and to whom it may concern . We all should always remember that, " Allah is the most all knowing… By Glorified. We have no knowledge except which you has thought us", thanks and praise be to Allah ". May 2008 Dr. Hussein H. Shehata Prof. of Accounting Al- Azhar University

7. Chapter One General background to shari'a principles of Islamic financing forms

8. (1/1) Shari'a principles of Islamic financing. -The main Shari'a principles that should be respected and complied with financing are : (1)Legitimate Dealings : المشروعية والحلال It means that all financing affairs should be carried out within the limits and rules of Shari'a principles. Avoiding areas of suspicion and forbidden. In general, finance dealings in essence are lawful except those forbidden by texts from the Glorious Qur'an or Sunnah .

9. (2) What is Good and Pureالطيبات Projects which would be financed, should be in good and pure dealings and be restrained from the illicit . Allah is Good and accepts nothing but the Good . (3)Adherence to Islamic priorities : الأولويات الإسلامية Muslim should adhere to Islamic investment . He should give priority to Daruriyatالضروريات (necessities) and Hajiyatالحاجيات (needs) over Tahsinyatتحسينات (commendable) , so as to avoid Wasting fundsالإسراف in unnecessaryالتبذير things.

10. (6) Protecting and Progressing Capital : حفظ وتنمية الأموال Preserving and multiplying capital through legal means is one of the main Islamic Shari'a's objectives, Therefore, capital should be invested by capable and qualified persons and through out safety projects. The Shari'a has forbidden certain kinds of activities because they lead to destroying of capital . On the other hand , capital should be invested to be multiplied and increased. Shari'a forbids Treasuryالاكتناز . Allah said: the ones who Treasure up gold and silver, and do not expend them in the way of Allah then give them the tidings of a painful torment " .

11. (4) Balance between Risks and Profit : التوازن بين الربح والمخاطر Islamic financing depends on dealings suspected with profit and losses, increasing and decreasing , gains and failure and so on. Muslim should balance between risks and profits to maintain Funds intact . (5) Diversification amongst Activities : التوزيع بين الأنشطة Muslim should invest funds in several projects to minimize failures and maximize gains. He should avoid to invest all funds in one project or highly risk ones .

12. (1/2) Islamic Financing Forms : صيغ الاستثمار الإسلامي The funds of an Islamic Bank are invested through many financing Forms (instruments) according to Shari'a principles. These are : • Mudaraba : المضاربة - Unrestricted Mudaraba. المضاربة المطلقة - Restricted Mudaraba. المضاربة المقيدة • Musharaka : المشاركة - Fixed Musharaka. المشاركة الثابتة - Decreasing Musharaka . المشاركة المنتهية بالتمليك - Permanent Musharaka . المشاركة الدائمة

13. Murabaha: المرابحة - Cash Murabaha . المرابحة الناجزة - Credit Murabaha.المرابحة لأجل • Bia-El-Salamبيع السلم • Bia-El-Istisnaa. بيع الاستصناع • Installment Deferred Sales. البيع بالتقسيط • El-Egara (Leasing) . الإجارة • Investment Securities . الاستثمارات في الأوراق المالية • Trading projects . التجارة • AL- Tawarrok التورق • Others. أخرى

14. Chapter Two بيع المضاربة Nature and case studies on Mudaraba Financing Forms

15. (2/1) Mudaraba Meaning : معنى المضاربة Mudaraba is a form of joint venture capital financing between two parties, the first provides capital, the second provides labour (efforts). In case of a profit, it is distributed between the parties as agreed between them . in case of loss, the capital provider would charge it , the labour losses his effort .

16. (2/2) Shari'a Principles of Mudaraba : الضوابط الشرعية للمضاربة • Shari'a principles (Law) of Mudaraba are : • The capital is provided by the first partner, who is called Rab-e-Malرب المال (the capital provider). He is not entitled to share in management. • The manager is appointed to manage the Mudaraba Business. He is called El-Mudarab, Rab-El-Amal . رب العمل • The capital can be in sort of cash, or assets which can be valued in monetary terms without suspicion or doubt . • Profits generated from Mudaraba are not realized untill capital is fully maintained .

17. Profit is divided between the partners according to the common rate due to each partner. No guarantee for each of giving them a minimum profit. • Loss is charged to the capital provider, the Mudaribالمضارب has lost his effort. The Mudarib may be held liable for losses in case of carelessness الإهمالand inattentivenessالتعدي , and negligence التقصير . • The accounts of Mudaraba should be checked by an experienced Auditor or by the Capital provider, as settled down in the contract .

18. (2/3) Mudaraba procedures as implemented by Islamic Banks: • If a client (Applicant) has the desire to joint-venture with an Islamic Bank in the form of Mudaraba, the following procedures should be carried out: • The Business-man (the client) proceeds a request to the Islamic Bank requiring capital through Mudaraba Financing Form, attaching some documents: such as : the Feasibility Study . • The Islamic bank would study and evaluate the request according Shari'a principles & Investment Criteria, and other Technical Rules. • In the case of accepting the request, the client would provide some sort of Guarantee, Documents against willful, negligence, carelessness and so on.

19. After that, Mudaraba financing Contract is settled down and signed by both partners . • The Islamic Bank should provide the Capital, and the Mudarab would manage the activities as settled down at the contract . • Every period, or at the end of the Mudaraba activities, the financial statements is prepared, which sow the results of affairs (profit or loss) which is distributed as settled down reflect) in the contract . • At the end of the Mudaraba activities , the liquidation accounts are prepared which declare the distribution of profit and loss and the share of each part . • The Mudaraba Contract could be renewed for another period, if the two parts wish and confirm this desire .

20. (2/4) Case studies on Mudaraba financing form : • Case (1): A Mudaraba contract is settled down between an Islamic bank and a Client, as follows : • the Islamic Bank provides capital of 10000000 S.R., and the client provides his efforts . • the subject activity of the Mudaraba is Trading in foods , for one year . • profit is divided as : 60% for the Islamic Bank, 40% for the client . • the result of activities was as follows : • Sales Income 12000 000 S.R. • Purchases Costs 9000 000 S.R • Mudaraba Expenses 1 000 000 S.R. • According to the previous data and information, the income statement is prepared as shown at the following page .

21. Mudaraba project with …………… Income statement For the period from ………….. to …………..

22. Case (2) : • If in the previous case the Sales income was 7000000, in this case, the Mudaraba activity results would be a loss of 3000000 S.R. the Bank would charge it , because the Mudarib has done his best . • According to the previous new Data and information the Mudaraba Income statement is prepared as shown below .

23. Mudaraba contract of …….. Income statement For the period from ……….. to …….

24. Chapter Three المشــاركة Nature and case studies on Musharaka Financing Forms

25. (3/1) Musharaka Meaning : معنى المشاركة • It Means : participation of two or more partners with defined amounts of capital and efforts, they carried out the activities according to Shari'a Principles . • Profit & Loss may be shared proportionately according to the agreement settle down in the contract . • There are two main kinds of Musharaka : Fixed and Decreasing

26. (3/2) Shari'a Principles of Musharaka : الضوابط الشرعية للمشاركة • Shari'a principles (Law) of Musharaka are : • The defined amount of capital provided by each party should be in case or assets which can be valued in monetary terms without suspicion or doubt . • Management of Musharaka affairs are implemented (carried out) by all partners or by one of them as agreed . • Musharaka could have a separate entity from their owners. • Profits generated from Musharaka are not realized until capital is fully maintained .

27. Profits may be distributed proportionately according to the shared capital provided by each partner or by other proportion which takes into the consideration the efforts . • Losses should always be distributed proportionately according to the shared capital provided by each partner . • Guarantee of capital or profits should not be given from a partner to another. • The partner who manages the project may be allowed a management Fee defined in advance in the contract . • Each partner have access to the books and records of the Musharaka project at any time . • Musharaka documents , records , books , accounts, statements and reports should be audited by partners or by Authorized Auditor . • Musharaka contract is normally for a fixed period, with an option to renew it to another period if the partners wish and confirm this desire .

28. (3/3) Musharaka procedures as implemented by Islamic Banks . • If a Business-man (client) has the desire to participate with an Islamic Bank in the form of Musharaka, the procedures to be followed are the same in the case of Musharaka mentioned before in chapter two . they are summarized as follows . • proceeding a request for financing through Musharaka form, the client may provide some documents ordered by the Bank . • the Islamic Bank would study the request and the other documents, and collect data about the financial position of the client . • the client would provide Guarantee against carelessness , willful, negligence and bad behavior . • writing (settling down) and signing the contract by partners .

29. Musharaka project is carried-out according to the principles, policies, plans and projects shown at the feasibility study . • Preparing financial statements every period to show the results of affairs and the financial position of the project . • Profit distribution after accepting and confirming the financial statements . • Losses may be differed to another period, if partners accept this desire . • At the end of the Musharaka period settled down in the contract, liquidation accounts are prepared and finishing the Musharaka contract . • The Musharaka contract could be renewed for another period if the partners wish and confirm this desire .

30. (3/4) Case studies on Musharaka Financing Form : Case (1) : fixed & continuous Musharaka . A Musharaka contract is settled down between an Islamic Bank and a Client according to the following terms . - Bank share in capital 6 000 000 S.R. - Client Share in capital 4 000 000 S.R. - Profits & Losses are distributed according to the shares in capital : 60% for the Bank, 40% for the client . - the summary of Musharaka project transactions were as follows : - Sales income 20 000 000 SR. - purchase cost 16 000 000 S.R. - Sales expenses 1 500 000 S.R. - Adm. Expenses 5000 000 S.R. - Depreciation 500 000 S.R. - Provisions 500 000 S.R. - Stock at the end of the period 1 000 000 S.R - Management free for the client 500 000 S.R.

31. Musharaka project with ……… Income statement For the period from …….. to ……..

32. Musharaka project with …………. Profit preparation statement For the year ended ……… Case (2) : Decreasing Musharaka A Musharaka contract is settled down between an Islamic Bank and a client according to the following terms : • Bank share in capital 4000000 S.R. • client share in capital 1000000 S.R. • Profits & Losses should be distributed according to percentage of share in capital .

33. Case (2) : Decreasing Musharaka : A Musharaka contract is settled down between an Islamic Bank and a client according to the following terms Bank share in capital 4000000 S.R. client share in capital 1000000 S.R. Profits & Losses should be distributed according to percentage of share in capital .

34. The client should buy every year from the Bank shares an amount by 1000000 S.R. according to the historical value . • the net profits for the first five years were as follow : • first Year 500 000 S.R. • second Year 750 000 S.R. • Third Year 750 000 S.R • Fourth Year 1 000 000 S.R. • fifth Year 1 000 000 S.R. • According to the previous data and information the profit preparation statement would be prepared as shown on the following page :

35. Capital shares & profit preparation For the period from ………. to …………

36. Chapter Four المرابحـــة Nature and Case studies on Bai-el Murabaha financing form

37. (4/1) Bai-El Murabaha Meaningمعنى بيع المرابحة • It means : added an agreed margin of profit above the initial price, or above the initial cost of the goods which would be sold to the client . • A person requests from another ……. A specific good and promise to buy it from him with a defined profit. This kind of transitions is permitted by Shari'a law . • There are two main forms of Murabaha : cash and deferred. the second form is widely implemented by the Islamic banks, and it is our concern in this Note – Book .

38. (4/2) Shari'a principles of Murabaha Shari'a principles of Murabaha are : • the requested goods should be defined well . • the initial (established) price should be also well known to the applicant . • the margin of profit should be defined . • the applicant who orders the goods may sign a promise to buy such goods when they are been sold and ready to deliver . • the seller should own the goods before selling them again to the applicant . • the applicant may provide a down payment to commit his request . He may be also asked to provide some of guarantee in such postdated cheques for the deferred amount . • the applicant should pay the installments in their due time . • Renewing the unpaid Balance of price (debt) through out increasing the debt is forbidding in Shari'a law. It is a sort of Usury ربا .

39. (4/3) Murabaha Procedures as implemented by Islamic Banks . • In the case of an applicant has the desire to by goods by Murabaha financing form through an Islamic Bank, the procedures should be followed are : • proceeding a request to the Bank for financing purchasing goods through Murabaha form . He may be asked to provide some documents which are required by the Islamic Bank . • the Bank will study the request and collect data and information about the financial position of the client . • in the case of accepting the request, the client would sign a promise to buy such goods , and pay the advanced installment (a down- payment ) as a deposit to commit his request .

40. the Islamic Bank must buy and own the required goods before selling them to the client . • when the required goods are been ready , the client would sign the contract and provide the Guarantee and the post-dated cheques for the deferred amount . • the Islamic Bank delivers the requested goods to the client as settled down at the contract . • the client should pay the installments over the period of time been agreed upon .

41. (4/4) Case Studies on Murabaha financing form : Case (1) : Calculating the initial costs of goods : قياس التكلفة الأصلية للبضاعة • According to Shari'a Rules, the initial costs of goods consist of : • the amount shown on the invoice . 1 000 000 S.R. • Delivery costs 100 000 S.R. • Insurance costs 50 000 S.R. • Tax 250 000 S.R. • Bank expenses 050 000 S.R. • Other expenses 50 000 S.R. • Total initial costs 1 500 000 S.R.

42. Case (2) : Calculating the margin profit and the installment : If a client has requested from an Islamic Bank to finance goods by Murabaha from they agreed on the following terms : • the initial costs 1 500 000 S.R. • the profit margin 10% • the down-payment 250 000 S.R. • Number of installments 10 • According to the previous data and information the Murabaha Statement would be prepared as shown on the following page .

43. Murabaha Statement First view : calculating the profile margin as a % of the initial costs before deducting the down–payment.

44. Murabaha statement Second view : calculating the profit margin as a % of the initial costs after deducting the down-payment .

45. Case (3) : Setting up the profit margin : From the Bank view-point, the profit margin way be distributed amongst time intervals According to accrual Base . For example : If total amount of instatements due in year 2000 was (800 000) and in year 2001 was (600 000) and the profit margin was (250 000) . so, 2001 as follows : Profit due to year 2000 = 250000/ 1400000 x 800000 = 142 857 S.R Profit due to year 2001 = 250000/ 1400000 x 600000 = 107 143 S.R. Total of profit margin = 250 000 S.R

46. Chapter Five بيـــع السلــم Nature and case studies on Bia-El-Salam financing form

47. (5/1) Bia-El-Salam meaning : معنى بيع السلم It is a form of financing agriculture goods . the defined price of a specified goods is paid in advance and the delivery would be curried out after a specified time . Goods, price and time of delivery should be defined well when the Salam contract is signed . (5/2) Shari'a principles of Bia-el-Salam: الضوابط الشرعية لبيع السلم They are : the subject of Salam contract should and commodities , the time and the place of delivery to avoid ignorance Defining the sale price of goods and commodities , the time and the place of delivery to avoid ignorance . the subject (goods) of Salam contract could be available at the time of delivery . the applicant of Salam may be asked to provide some of Guarantee All documents and the contract should be signed and confirmed .

48. (5/2) Shari'a principles of Bia-el-Salam: الضوابط الشرعية لبيع السلم They are : the subject of Salam contract should and commodities , the time and the place of delivery to avoid ignorance Defining the sale price of goods and commodities , the time and the place of delivery to avoid ignorance . the subject (goods) of Salam contract could be available at the time of delivery . the applicant of Salam may be asked to provide some of Guarantee All documents and the contract should be signed and confirmed .

49. (5/3) Bia-El-Salam procedures as implemented by Islamic Banks: • In the case of an applicant has the desire to sell goods or commodities to an Islamic Bank by Bia-el-Salam form, the following procedures should be carried out : • proceeding a request to the Bank for selling goods through Salam . He may be asked to provide some documents which have been required previously . • the Bank will study the request and collect data and information about the applicant . • in the case of accepting the request, the client would sign the Salam Contract and provide the Guarantee . • the Bank would pay the defined price to the applicant . • At the defined time of delivery , the applicant would deliver the goods to the defined place .

50. (5/3) A case study on Bia-el-Salam Financing Form : A Bia-el-Salam contract is settled down between an Islamic Bank and an applicant according to the following terms : • The Bank would buy 100 tons of Beans. Price per Ton 1000 S.R. • The time of delivery : after 6 months . • Place of delivery : the Bank's address . • According to the previous data and information the total sale price would be = 100 x 1000 S.R. = 100000 S.R. • In the previous case , if the Bank have signed another separate contract with another client to sell 100 tons of Beens , price per Ton 1200 S.R. the profit of the Bank would be 20000 S.R.