Accounting for Islamic

Banks and Financial

Institutions
Chapter 3
Accounting for Mudharabah Financing
Accounting for Mudharabah Financing 3.2

Mudharabah is a concept where the capital provider or

the Islamic bank (rab al-mal) and the small entrepreneur
(mudharib) become a partner.
The profits from the project are shared between capital
provider and entrepreneur, but the financial loss will be
borne entirely by the capital provider. This is due to the
premise that a mudharib invests the Mudharabah capital
on a trust basis; hence it is not liable.
for losses except in cases of misconduct. Negligence and
breach of the terms of Mudharabah contract, the
mudharib becomes liable for the amount of capital.
Accounting for Mudharabah Financing 3.2

There
are three fundamentals for
Mudharabah financing, namely:
1. The two contracting parties, i.e. rab al-mal
(capital provider) and mudharib
(entrepreneur)
2. The subject matter of the Mudharabah, i.e.
capital, labour and profit; and
3. The offer and acceptance.
Accounting for Mudharabah Financing 3.2

The conditions of Mudharabah pertain to three of the

fundamental elements of Mudharabah, i.e. the two
contracting parties, the capital and the profit.
Profit : the amount received that exceeds the capital
Profit Sharing Ratio should be determined at the time of
contracting and profit to be shared should be known
Can be limited to a period.
Accounting for Mudharabah Financing 3.2

With regards to the conditions for the two contracting

parties, i.e. rab ul- mal and mudharib, both of them must
have the capacity to enter into a contract of agency
(Wakalah). This is because, the authorisation by the rab ul-
mal or sahibul mal to the mudharib is considered to be a
form of agency, whereby, the rab ul-mal is the principal and
the mudharib is the agent.
Accounting for Mudharabah Financing 3.2
Islam is not a condition for both contracting parties.
No work interference by capital provider
The entrepreneur should comply with Shariah rules
The entrepreneur should comply with capital providers
instructions
No guarantee of recovery of fund .
Capital (can be trade & non-monetary assets)
No debt to be treated as capital
Manner of disbursement (lump sum or in several
installments).
 Forms of Mudarabah Transactions
Bilateral Mudarabah (Simple Re-Mudarabah (Two tier
Mudarabah) Mudarabah) :
One party of capital provider Three parties and includes
and another party of capital provider intermediate
entrepreneur Mudarib (entrepreneur) and
final mudarib (entrepreneur)

Multilateral Mudarabah: If there is one party of capital

provider and several parties of
Several parties of capital
entrepreneurs will it be still
provider and one party of
considered as multilateral
entrepreneur
mudarabah?
7
 Illustration of Bilateral Mudarabah
C1 provides RM100,000 to E1 If Loss is RM 20,000
and PSR is 70:30
C1 bears the loss of
If profit is RM40,000 RM20,000, and
C1 recovers RM100,000 - capital recover RM80,000
and shares capital
RM28,000- profit
E1 shares RM12000 profit

8
 Illustration of
Multilateral Mudarabah
C1 provides RM50,000 If loss is RM20,000
C2 provides RM50,000 C1 bears the loss of
RM10,000 and recover
PSR is 70:30, If profit is RM 40,000
RM40,000 capital
C1 recovers RM50,000 capital and shares
C2 bears the loss of
RM14,000 profit
RM10,000 and recover
C2 recovers RM50,000 capital and shares RM40,000 capital
RM14,000 profit
E2 shares RM12,000 profit

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 Illustration of Re-Mudarabah
CI provides RM100,000 If profit is RM40,000
PSR between C1 and E1 (intermediary) E2 shares profit of RM16,000 (40,000
is 70:30 x 0.4)
PSR between E1(intermediary) and E2 is E1 shares profit of RM 7,200 (40,000x
60:40 0.6x 0.3)
C1shares RM16,800 (40,000 x 0.6x0.7)
If loss is RM 20,000
C1 bears the loss of RM20,000 and
recover RM80,000 capital

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Recognition and Measurement of
Mudaraba Financing
FAS 3, Mudaraba Financing is a standard for the provision
of mudaraba financing by the Islamic bank and does not
deal with the deposit side of receiving the funds on
mudaraba basis. However, in this chapter we will consider
both.
When the capital is paid to the mudarib or placed in his
disposition (for example, credited to his account) then
Mudaraba financing capital is recognized by debiting
Mudaraba Financing and crediting cash.
If the capital is paid in installments, each installment is
recognized as capital when paid.
Recognition and Measurement of
Mudaraba Financing
Ifpayment of capital is conditional of an
occurrence of a future event or delayed to a
future time, capital is recognized only when it is
paid to the mudarib.
Ifthe capital is in the form of non-monetary
assets such a plane or building then the heading
of non Monetary mudaraba asset.
Recognition and Measurement of
Mudaraba Financing
If capital provided by the Islamic bank is in kind (trading
assets or non-monetary assets), the capital shall be valued
at fair value of the assets. Any difference between fair
value and book value shall be recognized as profit or loss
to the bank.
Expenses of contracting procedures such as feasibility
studies are not considered mudaraba capital unless
specifically agreed.
Accounting issues on Mudarabah
ILLUSTRATION RECOGNITION OF MUDARABA FINANCING
Bahrain Islamic Bank executes a mudaraba contract for $1,000,000
with Babul Bahrain constructions on 1 Muharram 1428. The feasibility
study and legal expenses cost the bank $50,000 and was paid by the
Bank. The $1,000,000 is to given to babul Bahrain constructions for
their use in the mudaraba as follows:
1 Muharram 1428: $200,000 cash +$300,000 (fair value) of a crane which
was used for ijarah purposes by the bank in a previous assets with a book
value of $400,000.
1 Safar 1428: $200,000 fair value of construction materials which was left
over from terminated istisna contract, the carrying value was $150,000.
1 Jamada I, : $300,000 in cash.
Required: Journal entries in the books of Bahrain Islamic Bank for
the above transactions which were executed as scheduled.
ILLUSTRATION RECOGNITION OF MUDARABA FINANCING
One-period Mudharaba
Example 2
Islamic Bank signed a mudharaba contract for $300,000 with Al nahda
company on January,1 2014. The $ $300,000 is to given to Al nahda in cash at
the date of contract.
The profit ratio sharing (PRS) is 60-40 between the Bank (Rabb al-Mal) and Al
nahda (Mudarib) respectively
The bank received the following payments from Al nahda company as follows:
Jan.15 : 100,000
Feb. 15: 70,000
Mar. 5: 100,000
Mar. 15: 80,000 and the parties agreed to end the Mudaraba successfully
Required: Journal entries in the books of Islamic Bank for the above
transactions .
:Solution
300,000Jan.1 : Dr. Mudharabah Financing
300,000 Cr. Cash

100,000 Jan.15 : Dr. Cash

100,000 Cr. Mudharabah Financing

70,000 Feb. 15 : Dr. Cash

70,000 Cr. Mudharabah Financing

100,000 Mar. 5 : Dr. Cash

100,000 Cr. Mudharabah Financing

80,000 Mar. 15 : Dr. Cash

80,000 Cr. Mudharabah Financing
:Solution
Mudharabah profits = Received payments - Mudharabah Financing
= 350000-300000 = 50000
The bank share = 60% x 50000 = 30000
The Mudareb share = 40% x 50000 = 20000
50,000Mar. 15 Dr. Mudharabah Financing
30000 & lossesCr. Investment profits
Cr. Current accounts (Al nahda company ) 20000
 Example 3
Data for Al nahda company Mudharabah Financing , are presented in
Example 1 , suppose that the payments received amounted to 270000
and
1. There is no evidence about negligence from Mudarib
Mudharabah losses = Received payments - Mudharabah Financing
= 27000-300000 = (30000)
The bank share = 30000
The Mudareb share = 0
30,000Mar. 15 Dr. Investment profits & losses/ Mudharabah
30000 Cr. Mudharabah Financing
2. The losses resulted from negligence of Mudarib
The bank share = 0
The Mudareb share = 30000
Mar. 15 Dr. Mudaraba Recievables (Al nahda company ) 30,000
30000 Cr. Mudharabah Financing
 Some Legal Principles of
Mudarabah Transactions (continued)

Profit Recognition
1. Realisation Method: according to Hanbali and Shafie is when the
revenue is earned i.e. after determining its costs
2. Distribution Method: according to Maliki it is realised upon
distribution between the two parties

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Measurement of Mudaraba Capital at the end of the
financial year after contracting.

Mudaraba capital should not be revalued subsequent to the

execution of contract.
Any repayment of capital should be deducted from the Mudaraba
Financing Account.
If a partial loss of the capital occurs (e.g. theft or fire) before the
work on the mudaraba is started (and this is NOT caused by
negligence of the mudarib.), this should also be deducted from
mudaraba financing account and debited to pofit and loss account.
If the whole of the mudarba capital is lost, (not due to mudrib)
then the Islamic bank must bear the loss, and terminate the
mudarba contract.
Any unpaid amounts remaining becomes a receivable of the bank
from the ex mudarib.
Recognition of the Islamic banks share
in the profit and losses
If a mudaraba starts and finishes within the financial year of the
bank, profit and losses (banks share) should be recognized by the
bank in that financial year.
If a mudraba transaction carries on after the financial year end, the
profit or losses should be recognized in the accounts for that period.
To the extent that profits are distributed. The Islamic Banks share of
losses should be recognized to the extent such losses are deducted
from the Mudaraba capital.
If the mudraba is terminated or settlement is made and the mudarib
has not paid the profits to the bank, this will be treated as a
receivable from the mudarib.
Recognition of the Islamic banks share
in the profit and losses
Losses due to liquidation is recognized at the time of liquidation by reducing
the Mudaraba capital.
ANY MISCONDUCT OR NEGLIGENCE OF THE MUDARIB RESULTING IN LOSSES
WILL BE BORNE BY THE MUDARIB AND IT BECOMES A RECEIVABLE DUE FROM
THE MUDARBIB.
Non Monetary MudarabaH capital

Is discouraged by fuqaha
Valued at fair value , any difference between fair value and book value goes
to the profit and loss
Any provision made for the decline in the value of Mudaraba assets should be
DISCLOSED in the notes to the accounts.
AAOIFI : Presentation and Disclosure of Mudarabah
Financing

Balance Sheet

Mudaraba Financing ( Non Monetary XX

Mudarabah Asset)*
Less : Provision for decline in value of (XX)
Mudarabah Assets
Net Mudarabah Financing XX
*Jointly or self financed assets

Income statement
Mudarabah income XX
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Accounting Problem
Bank Syariah Malaysia Berhad contributed $2,000,000 for a four-year Mudaraba
financing contract (Mudarabah Muqayaddah) at the profit sharing ratio of 2:1
between the Bank (Rabb al-Mal) and Ihsan Corporation (Mudarib) respectively.
Assume that the venture incurred a loss of $150,000 in the first year; realized
profit of $375,000 in the second year; incurred a loss of 250,000 in the third year;
and realized profit of $350,000 in the fourth year.
Required:
A. Prepare the necessary journal entries to recognize asset and profit/loss of the
above transactions, and show how profit/loss will be allocated between the Bank,
and the Mend of first, second, third and fourth year, if the profit of Mudarabah is
determined at the end of:
I. each period
II. at the end of the contract
B. Comment on the impacts different basis of profit allocation (i.e. each period vs.
end of the contract) on the income of the Bank and the Mudarib.
C. What are the different forms and types of Mudarabah contracts?
Solution:
Each period method :

Year 0: Dr. Mudharabah Financing 2,000,000

Cr. Cash 2,000,000

Year 1: Dr.Profit and Loss 150,000

Cr. Mudharabah Financing 150,000
( loss in 1st year )
Year 2 : Dr. Cash / Receivable (2/3 x 375,000) 250,000
Cr. Profit and Loss 250,000
(Profit in 2nd year )
Solution:
Each period method :

Year 3 : Dr. Profit and Loss 250,000

Cr. .Mudharabah Financing 250,000
( loss in 3rd year )
Year 4 : Dr. Cash / Receivable (2/3 x 375,000) 233,333
Cr. Profit and Loss 233,333
(profit in 4th year )

Dr. Cash / Receivable 1,600,000

Cr. Mudharabah Financing 1,600,000
( Capital repayment , year 4 )
Solution:
End of contract Method:
End of contract Method:

Year 1: Dr. Mudharabah Financing 2,000,000

Cr. Cash 2,000,000

Year 4 : Dr. Cash / Receivable 2,000,000

Cr. Mudharabah Financing 2,000,000
Solution:
:End of contract Method
Profit / Loss
1. Year 1 ( 150,000)
2. Year 2 375,000
3. Year 3 ( 250,000)
4. Year 4 350,000

Year 4 : Dr. Cash / Receivable 216,667

Cr. Profit and Loss 216,667
Comparison between the different
methods:
Comparison between the different
methods:
Different method (end of contract vs. Each period) will lead to different
amount of income recognized by both the Rabbul-Mal and Entrepreneur.
For each period, loss during the contract will borne by Rabbul Mal, thus
reduced total profit. Mudharib only earned profit not loss (protect Mudharib)
may lead to moral hazard.
For end of contract ,loss will be absorbed by profit, some argued not true
Murbahah, some others argued that we should consider it as a project basis.
Method of profit recognition must be transparent to both parties at the
beginning of the contract to avoid abuse by one party over the other.