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Chapter 12: Accounting for Istisna’ and Parallel
Istisna’
‫ﻋﻤﻠﻮ‬
‫ﻴﺎ‬
‫ﻗﺪ ﺳ‬
‫ﻴﻞ ﺟﻔﺎ ﻛﺎﻟﺠﻮ‬
‫ﻦ ﻣﺤﺎ ﻳﺐ ﺗﻤﺎﺛ‬
‫ﻳﻌﻤﻠﻮ ﻟﻪ ﻣﺎ ﻳﺸﺎ ﻣ‬
‫ ﻟﺸﻜﻮ‬
‫ﺒﺎ‬
‫ﻦ ﻋ‬
‫ﻴﻞ ﻣ‬
‫ﺷﻜﺮ ﻗﻠ‬
They made for him whatever he wished of sanctuaries, and statues, and basins as
[large as] great watering - troughs, and cauldrons firmly anchored. [And We said:]
“Labour, O David’s people, in gratitude [towards Me] and [remember that] few are
the truly grateful [even] among My servants!”
‫ﺛﺒﺘﺖ ﻣﺸﺮوﻋ ﺔ اﻻﺳﺘﺼﻨﺎع ﺑﺎﺳﺘﺼﻨﺎع اﻟﻨﺒﻲ )ص( اﻟﺨﺎﺗﻢ واﻟﻤﻨﺒﺮ وﺑﺎﻻﺳﺘﺤﺴﺎن واﻟﻘﻮاﻋﺪ اﻟﻌﺎﻣﺔ ﻓﻲ‬
.‫اﻟﻌﻘﻮد واﻟﺘﺼﺮﻓﺎت واﻟﻤﻘﺎﺻﺪ اﻟﺸﺮﻋ ﺔ‬
The legitimacy of Istisna’a is based on the request of the Prophet, peace be upon him,
that a pulpit (a platform) for preaching and a finger ring be manufactured for him. An
Istisna’a contract is also permissible on the basis of the principle of istihsan (public
interest or good), the general principles of contracts and transactions and the objectives
of Shari’a.
Chapter
12
CHAPTER LEARNING OBJECTIVES:
At the end of this chapter you will, insha Allah you will be able to:
i.
ii.
iii.
iv.
v.
Explain the meaning of Istisna’a’ and parallel istisna’a’ and how these
contracts are used by Islamic banks to finance customers
List the principles of istisna’a’ and as well as explain the shari’a rules.
Journalise accounting entries for istisna’a’ and parallel istisna’a’.
Prepare the balance sheet and income statement extracts for
istisna’a’ and parallel istisna’a’ transactions
Apply shari’a and accounting principles as per FAS 10 to solve
accounting problems for complex events.
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Chapter 12: Accounting for Istisna’ and Parallel
Istisna’
12. 1 Introduction
Besides salam, istisna’a’ is the other contract where a sale can be made without the
subject matter of the contract being in existence at the time of contracting. Whereas salam
is a contract for delivery of a commodity, which might be grown or bought by the muslaim
ileihi to be delivered to the muslam at a future date, istisna’a’ is a contract to manufacture
the goods to specification and deliver the manufactured goods to the buyer at a future
agreed date, the payment being in advance or deferred or in installments.
Islamic banks have used this contract to finance infrastructure projects such as power
plants, planes, highways etc. How do the Islamic banks do this when they are not
construction contractors, airplane manufacturers or highway experts? These they do by
means of a parallel istisna’a contracts where the manufacturer is commissioned to
manufacture and deliver to the Islamic bank (actually their customer – imagine a plane is
parked next to a Islamic bank building!) which in turn is delivered to the bank’s customer.
From an accounting point of view, istisna’a is complex to account for as the costs of
construction has to be accumulated and progress payments billed and tracked as in
construction contract accounting IAS 11. Further the most important event is the
recognition of profits using the percentage of completion method which is now the
standard practice under IAS 11, when the outcome of a contract can be estimated
reliably. FAS 10, however, allows the completed contracts method, where no profits are
recognized but costs are accumulated to the amount they are expected to be recoverable.
Following the prudence concept, if any time during the istisna’a’ contract, there is a
expected loss or the cash equivalent value of the work in progress is less then the contract
amount receivable, then the work in progress will have to be written down to the cash
equivalent value.
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Chapter 12: Accounting for Istisna’ and Parallel
Istisna’
12.2 Definition and financing model of istisna’a’ and parallel
istisna’a’
Definitions
Istisna’a and Parallel Istisna’a
Istisna’a
It is a sale contract between al-mustasni’ (the ultimate purchaser) and al-sani’,
(seller) whereby al-sani’ - based on an order from the al-mustasni’- undertakes
to have manufactured or otherwise acquire al-masnoo’ (subject matter of the
contract) according to specification and sell it to al-mustasni’ for an agreed
upon price and method of settlement whether that be at time of contracting, by
instalments or deferred to a specific future time. It is a condition of the Istisna’a
contract that al-sani’ should provide either the raw material or the labour.
Parallel Istisna’a
if al-mustasni’a (the ultimate purchaser) does not stipulate in the contract that
al-sani’ (seller) should manufacture the al-masnoo’ by himself, then alsani’ may enter into a second Istisna’a contract in order to fulfil his
contractual obligations Contract losses
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Chapter 12: Accounting for Istisna’ and Parallel
Istisna’
Manufacturer
ISLAMIC
BANK
(al sani in the
istisna’ contract
and al mustasni in
The parallel
istisna contract)
3
Al Sani in the
parallel istisna
2
4
1
Bank’s
customer
Al mustasni
in the istisna’
contract
Fig 12.1 Istisna’a’ with parallel istisna’a’ financing
1
2
The customer executes a contract with the Islamic bank to manufacture
and deliver goods to specification. Usually paying a deposit. The
customer pays a series of progress payment to the bank on being billed
The bank enters into an agreement with the manufacturer to manufacture
and deliver the goods to the bank at an agreed future date. Normally a
deposit and a series of progress payments are made when the
manufacturer bills the bank.
3
The manufacturer manufactures and bills the bank periodically and delivers
the goods to the bank (actually the customer) at the end of the contract.
4
The Islamic bank makes a series of billings to the customer based on
istisna’a contract price and delivers the manufactured goods to the
customer on completion.
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Chapter 12: Accounting for Istisna’ and Parallel
Istisna’
12.3 Istisna’a’ and Parallel Istisna’a’ fiqh principles, rules and
complexities.
1
Legitimacy
Istisna’a is considered a special case of salam. It grew out out of the Salam
contract and has similar provisions and rules. It arose out of jurisprudential
engineering of the Hanafi school which approved its validity based on
istihsan (equity). Istisna’a is valid also based on ibaha (permissibility if not
contrary to scriptural text). Hence, we can say Istisna’a is valid from the
consensus (ijma) of islamic scholars.
2
Conditions for validity: Al Masnoo
(Subject Matter)
The subject matter be known and specified to the extent to remove gharar.
Specifications to include:
(i) kind e.g car, aeroplane or house
(ii) type e.g. Toyota car, boeing aeroplane, low cost house
(iii)quality; according to table of specifications.
3
Conditions for validity: Date of Delivery.
Initially, hanafis did not allow fixing of delivery date, however, AAOIFI
scholars have agreed to all the fixation of future delivery date in order to
avoid gharar in line with resolution of the fiqh academy
4
Price
The price should be known to the extent of removing lack of knowledge
(fixed?) It cannot be increased or decreased on account of the normal
increase or decrease in commodity prices of labour or cost of labour.
Similarly, if the bank gets a discount from the manufacturer or if the actual
costs are substantially less then expected, the ultimate purchaser is not
entitled to any discount. According to the shari’a standard, a cost plus
istisna’a contract is NOT allowed
A price change is allowed if the specifications of al masnoo are modified
by the contracting parties subject to mutual agreement or due to unforeseen
contingencies.
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Chapter 12: Accounting for Istisna’ and Parallel
Istisna’
5
Binding nature of contract
There is a difference of opinion whether the istisna’a contract is binding although its
validity has never been questioned. If the contract is not binding, then the mustasni or al
sani can rescind the contract at the time of delivery. However, the Islamic Fiqh Academy
has decreed that the Istisna’a contract is binding provided that certain conditions are
fulfilled.
However, if the al masnoo is not according to specification, al mustasni has the option to
revoke the contract.
6
Legal consequences of istisna’a
It transfers reciprocally, the title of ownership between al mustasni and al sani and entitles
the al sani to the contract price.
7
Guarantee and Penalty
Al mustasni has a right to get collateral for the amount he has paid.
He also the right to get collateral for delivery in accordance wth specification
and on time
Further, al sani has the right to secure collateral to guarantee that the price is
payable on time.
Al mustasni can insert a penalty clause in the contract against unfullfillment
of obligations .
8
Termination of contract
The contract of Istisna’a’a may be terminated under the following
conditions:
(a) Normal fulfillment of obligations by both parties.
(b) Mutual consent of both parties.
(c) Judicial rescission of the contract. This is if a reasonable cause
arises to prevent the execution of the contract or its completion,
and each party may sue for its rescission(1).
9
1
()
Options on Non-compliance
See Recent Civil Islamic Legislations; Abdallah, A.A., op. cit, pp. 61-62.
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Chapter 12: Accounting for Istisna’ and Parallel
Istisna’
If al-musnoo’ is not in conformity with specification, al-mustasni’ has
the following options:
(a) reject al-masnoo’ or
(b) accept it without seeking damages.
9
Parallel Istisna’a
If al-mustasni’a (the ultimate purchaser) did not stipulate in the
contract that al-sani’ (seller) should manufacture the al-masnoo’ by
himself, then al-sani’ may enter into a second Istisna’a’a contract in
order to fulfil his contractual obligations in the first contract. This new
contract is known as parallel Istisna’a’a, which is in essence a
subcontract whereby the obligation of al-sani’ in the first contract are
carried out. Nevertheless,
(a) The Islamic bank as al-sani’ in the first contract will remain
solely responsible for the execution of his obligations as if the
parallel contract is non-existent. Hence, al-sani’ in the first
contract would remain liable for any default, negligence or
breach of contract ensuing from the parallel contract.
(b) Al-sani’ in the parallel Istisna’a’a is accountable to al-mustasni’
(Islamic bank) in the way and manner by which he performs his
obligations. He has no direct legal relationship with al-mustasni’
in the first contract. The second Istisna’a’a is a parallel contract,
but not a contingent transaction on the first contract. Legally
speaking they are different contracts with respect to rights and
obligations.
(c)
2
()
The Islamic bank as al-sani’ is liable to al-mustasni’ with regard to
any mal-execution of the subcontractor and any guarantees arising
therefrom. It is this very liability that justifies the validity of the
parallel Istisna’a’a and which also justifies the charging of profit
by the Islamic bank, if any (2).
Abdallah, A.A., op. cit., pp. 62-66.
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Chapter 12: Accounting for Istisna’ and Parallel
Istisna’
Similarities and Differences between Salam and Istisna’a’
Subject
Salam
Istisna’a’
Rules and comments
1. Subject matter
of the
contract.
Al-muslam fihi
Al-masnoo’
Deferred goods,
specification.
2. Price.
Paid at time of
contracting.
It is permissible to:
The means of settlement (in
advance, deferred, or instalments)
constitutes the main difference
between Salam and Istisna’a.
One.
ay it at time of
contracting;
known
by
Two.
efer it; or
Three.
ay it in
instalments.
3. Nature of
contract
Binding
Binding
4. Parallel
contract.
Parallel Salam
Parallel Istisna’a
Salam is originally binding on its
parties, However, Istisna’a is
considered binding based on the
views of some fuqaha for the
sake of maslaha and for not
contravening any Shari’a rule.
Both parallel Salam and parallel
Istisna’a are valid provided that:
§ the two contracts are legally
separated;
§ the legal relationship between
the parties to each contract is
separate; and
§ the rights and obligations of
each contract are separate.
12.4 Recognition of Istisna’a’a transactions and
journal entries.
FAS 10, Istisna’a’ Financing is a standard which addresses the accounting
rules of istisna’a and parallel istisna’a contracts in the financial statements
of Islamic financial institutions.. These include measuring and recognizing
the costs and revenue from both these contracts and gains and losses arising there from as well
as the presentation and disclosure in the financial statements. The main transactions and their
treatments are as follows.
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Chapter 12: Accounting for Istisna’ and Parallel
Istisna’
12.4.1 Accounting treatment in the books of the Islamic bank as the seller (al sani’).
DR
Direct Istisna costs eg. Materials,
labour costs of producing al
masnoo
Indirect Istisna Costs which can be
allocated on an objective basis to
the istisna contract
CASH
Istisna work in
progress
account
CASH
PROFIT & LOSS
ACCOUNT
Portion of profit margin
recognized in the financial period
Pre operating Costs
(before contracting,
when incurred)
Deferred costs
account
Pre operating Costs
After contracting
Istisna work in
progress
account
Progress payment billings
to al mustasni
Receipts on Account
CR
ISTISNA’
ACCOUNTS
RECEIVABLE
CASH
CASH
Deferred costs
account
ISTISNA
BILLINGS
ACCOUNT
ISTISNA
ACCOUNTS
RECEIVABLE
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Chapter 12: Accounting for Istisna’ and Parallel
Istisna’
At year end profit recognition using percentage of completion method:
ISTISNA
REVENUE
Proportion of revenue recognized =
cumulative cost incurred x contract price
total expected cost
cumulative cost incurred
Profit recognized for the period =
cumulative cost incurred x[ contract price-total
total expected cost
expected cost]
COST OF
ISTISNA’
REVENUE
ISTISNA’
WORK IN
PROGRESS
As can be seen from the above illustration, the following are the main transactions and
their treatment.
(i) all direct and indirect istisna’a costs are debited to a istisna’a works in progress
account. Direct costs are those such as material and labour incurred the manufacture of al
masnoo’. Indirect costs relating to the contract which can be allocated on an objective
basis are also debited to this account. However general administration, selling, research
and development costs should not be included under istisna’a contract costs.
(ii) all pre-operating contract expenses are debited to a deferred costs before the
execution of the contract and upon execution of the contract transferred to the Istisna’a
work in progress account.
(iii) Amounts billed to al-mustasni’ will be debited to istisna’a accounts receivable account
and credited to istisna billings account.
(iv)if the percentage of completion method is used , then a part of the contract price
commensurate with the work completed is recognized in an istisna revenue account using
the formula:
ISTISNA REVENUE = ACCUMULATED COST TODATE X CONTRACT PRICE
TOTAL EXPECTED CONTRACT COST
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Chapter 12: Accounting for Istisna’ and Parallel
Istisna’
and the portion of the profit recognized is debited to istisna’a work in progress account
using the formula below:
PROFIT FOR THE ACCOUNTING PERIOD
= ACCUMULATED COST TODATE X [CONTRACT PRICE- TOTAL EXPECTED CONTRACT COST]
TOTAL EXPECTED CONTRACT COST
(v) Completed contract method.
This method is used when both the percentage of completion and the expected cost to
complete the contract cannot be reasonably estimated, no contract revenue or profit is
recognized until the completion of the contract. In this case, the accumulated costs will be
carried forward in the istisna’a work in progress account.
(vi) Deferred profits
Unlike a salam contract, where the payment must be made in advance, in an istisna’a
contract, the price is can be paid in advance, in installments or deferred. The normal
practice is the payment is made in installments. For Islamic bank customers, the financing
motive means that the installments period will often run after the contract is completed and
the al masnoo delivered. In this case, all the profits cannot be recognized in the accounts
before the time the al-masnoo’ is delivered. A portion of the profits pertaining to the unpaid
installments should be deferred. The deferred profit must be deducted from the Istisna’a
Accounts Receivable in the Balance Sheet.
The standard requires that the preferred method of allocation of deferred profits is by
proportionate allocation of deferred profit over the future financial period of credit, whereby
each financial period will carry its portion of profit, whether or not, cash is received. This
statement is not clear, it could mean the bank can allocate the deferred profit by equally
over the remaining credit period (similar to straight line depreciation) or in proportion to the
amounts receivable per payment schedule. The latter appears as a better interpretation.
However, if the bank’s SSB or regulatory authorities approve, then the deferred profit is
allocated in proportion to the installments received.
There seem to be an error in the English version of the standard FAS10,, para 11
(2/3/2). The English version defines the deferred profit as the difference between the
contract price and the installments paid during the contract term. This is actually the
accounts receivable. Netting this amount against the Istisna’a Accounts Receivable will
make it nil. In the Arabic version of the standard, no such definition is given. Since the
Arabic version of the standards are to be followed in case of conflict, this definition is
ignored in this book.
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Chapter 12: Accounting for Istisna’ and Parallel
Istisna’
(vii) Advance payment by al mustasni.
The Islamic Bank may (not must) waive a part of its profit in case of advance payment and
this rebate will be deducted from Istisna’a accounts receivable and deferred profits
(Dr. Deferred profits , Cr Istisna Accounts Receivable)
The same treatment is effected if the al mustasni paid the whole amount and the bank
refund the rebate to the customer.
(viii) Change orders and additional claims
If the al mustasni requests for a change in the specifications in the al masnoo or additional
work, and the al sani agrees to this, the value and cost of the change orders must be
added to the istina’a costs and revenues respectively. Additional claims made by al sani
in excess of the contract price for delays, errors in specifications and designs or other
causes of unanticipated costs caused by al mustasni’, an additional amount of revenue
equal to the additional costs should be recognized provided, there is a legal basis
supported by verifiable evidence (see definition below for further conditions). If the
conditions for recognition of additional claims are not satisfied, then an estimated value of
these claims should be disclosed in the notes to the financial statements.
Definitions
Change orders
Approved modifications in specifications, quantities, design, or other attributes defined in
the original Istisna’a contract the implementation of which affects contract costs.
Additional claims
Amounts in excess of the agreed Istisna’a contract price which are claimed by al-sani’ for
delays, errors in specifications and designs or other causes of unanticipated costs caused
by al-mustasni’. Recognition of these claims by al-sani’ requires the satisfaction of the
following conditions:
(a) The existence of a legal basis for the additional claim supported by objective and
verifiable evidence.
(b) Claims must be due to circumstances that were unforeseeable at the contract date
and are not the result of the deficiencies, fault or negligence of al-sani’.
(c) Costs associated with the additional claim are identifiable and reliably estimable.
(ix) Maintenance and Warranty costs.
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Chapter 12: Accounting for Istisna’ and Parallel
Istisna’
These costs should be accounted for on an accrual basis. These costs should be
estimated and matched with istisna’a revenue. Actual maintenance and warranty
expenses should be charged against an Allowance for Maintenance and Warranty
Account, when carried out by the Islamic bank. In case of a parallel istisna’a, the
maintenance and warranty costs should be charged as incurred to expense accounts.
Summary of Journal Entries for Istisna in the books of the bank
No.
1
2
Transactions /Events
Pre contracting costs
Recognition of direct
and indirect expenses on
contract
On execution of contract,
3 precontract deferred costs
transferred
4
5
Completed contract method
Portion of profit and revenue
recognized
Progress Payment billings to
al mustasni
DR
Deferred costs
Istisna’a Work in
Progress
CR.
cash
Cash
Istisna’a Work in
Progress
Deferred costs
Istisna’a Work in
Progress (with profit
recognized)
Istisna Revenue
(with revenue
recognized)
Cost of Istisna’a
Revenue (with
difference between
revenue and profit)
Istisna Accounts
Receivable
Cash
Istisna Billings
account
Istisna’a Accounts
Receivable
6 Receipts of Billings
If part of progress payments
falls after al masnoo’ is
7 delivered. Deferred profits
are set up and amortized in
proportion to installments
Istisna Revenue
Deferred Profits
(if profits recognized
exceed the proportion
of installments
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Chapter 12: Accounting for Istisna’ and Parallel
Istisna’
receivable
8
10
11
12
13
14
receivable)
Deferred
profits
recognized in proportion
to installments receivable
Dr Deferred profit
Profit and Loss
account
Early
Settlement
of
installments
by
al
mustasni and the bank
gives rebate.
Contract
losses
or
reduction in value of
istisna work in progress
below cash equivalent
value
change
orders
and
additional claims and
requisite conditions are
met.
When additional
costs are incurred
Deferred Profits
Istisna’ Accounts
Receivable
Dr Profit and Loss
Istisna work in
progress
Dr Istisna work in
progress
Cash
Maintenance
warranty costs
and
Expenses on maintenance
and warranty
Dr Istisna’a Accounts
Receivable
Profit and Loss
Allowance for
maintenance and
warranty
Istisna Revenue
Allowance for
maintenance and
warranty
Cash
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Chapter 12: Accounting for Istisna’ and Parallel
Istisna’
Al mustasni refuses to
take delivery of al
masnoo
Istisna Asset account
Disposal of refused al
masnoo.
Cash
Profit and Loss
15
Istisna work in
progress
Istisna asset account
(any loss due to cev
less than carrying
value
Istisna Asset account
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Chapter 12: Accounting for Istisna’ and Parallel
Istisna’
12.4.2 Accounting treatment in the books of the Islamic bank as the buyer(al
mustasni) – parallel istisna’a contract.
(i) Only the completed contracts method is recognized in the case of parallel istisna’a
because both the revenues and costs (being billed to the bank by al sani) are known with
reasonable certainty.
(ii) The costs billed by the contractor to the Islamic bank are accumulated in a Istisna’a
costs account (as opposed to an Istisna’a work in progress account in istisna’a contract).
The credit entry is to an Istisna’a accounts payable. The recognized portion of profit
for a financial period is added to the Istisna’a cost account.
Progress Billings of
subcontractor to the bank
Portion of profit margin recognized
in the financial period
Al Masnoo received not to
specification and cev lower than
carrying value; difference between
cev and carrying value
ISTISNA’
COSTS
ACCOUNT
ISTISNA’
COSTS
ACCOUNT
PROFIT AND
LOSS ACCOUNT
ISTISNA
ACCOUNTS
PAYABLE
PROFIT AND
LOSS ACCOUNT
ISTISNA’
COSTS
ACCOUNT
(iii) Receipt of al-masnoo’
When the contractor delivers al masnoo to the bank, in conformity to specifications and
schedules., the bank should record the asset at historical cost (i.e. book value) of the
Istisna’a cost account. The balance of the Istisna’a costs should be transferred to an asset
account reflects the nature of the asset. E.g. fixed asset or investment in ijarah assets or
istisna assets.
(iv) Late delivery of al masnoo’
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Chapter 12: Accounting for Istisna’ and Parallel
Istisna’
IN case delay is due to negligence or fault of al sani and the Islamic bank is entitled to
compensation for damages resulting from the delay, this should be first deducted from
performance bonds. If insufficient, the deficit is an Istisna’a accounts receivable from al
sani’ subject to allowance for doubtful debts.
(vI) Al Masnoo’ not conforming to specifications
If the bank declines to accept it, and it does not recover all its payents to the al sani’, the
un-recovered balance becomes a receivable subject to allowance for doubtful debts.
If the bank accepts al masnoo’ it will be measured at the lower of the cash equivalent
value or historical cost. Any resulting uncompensated loss should be written off for the
current accounting period.
(vii)if al Mustasni (client) refuses to receive al-masnoo’
The masnoo will be carried at lower of cash equivalent value or historical cost. Any
resulting loss will be written off in the accounting year in which it is realized.
Summary of journal entries in the books of the bank as buyer (al mustasni)
No.
1
2
3
Transactions /Events
Pre contracting costs
On
execution
of
contract,
precontract
deferred
costs
transferred
Billings received from
contractor
4 Payments to contractor
At end of year, istisna’a
profits recognized using
5 percentage of completion
method
DR
CR.
Deferred costs
cash
Istisna’a Costs account Deferred Costs
Istisna’a Costs account Istisna’a Accounts
Payable
Istisna’a Accounts
Cash
Payable
Istisna costs account
Istisna Revenue
Costs of Istisna account
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Chapter 12: Accounting for Istisna’ and Parallel
Istisna’
Receipt of al masnoo in
6 conformity with
specifications and schedule
Receipt of al masnoo not in
conformity to
7 specifications, value
reduced to cash equivalent
value
Islamic bank does not
8 accept al masnoo which is
not due to specs
When installments are due
to al sani (subcontractor)
after al masnoo is delivered.
Profit applicable to undue
installments deferred
Istisna Asset account
Istisna costs account
Dr Profit and Loss
Dr Istisna Asset
Istisna costs
Dr Istisna accounts
receivable
Istisna costs
Istisna Revenue
Deferred profit
12.5 Asset and Liability measurement
AAOIFI : presentation and disclosure of Istisna’a
Balance Sheet
Istisna Work in Progress (including profits recognized)
(in case of parallel istsna – Istisna costs
XX
Less Istisna Billings
(XX)
Less loss recognized/reduction to cev
(XX)
Less Allowance for maintenance costs
(XX)
Net Istisna work in progress
XX
Balance Sheet (continued)
Istisna Accounts receivables
XX
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Chapter 12: Accounting for Istisna’ and Parallel
Istisna’
Less deferred profits
Less allowance for doubtful debts
Net Istisna’a Accounts Receivable
(XX)
(XX)
XX
Balance Sheet (Liability side)
Istisna Accounts Payable
XX
Income Statement
Istisna’a Revenue
Less costs of istisn’a Revenue
Less Deferred profits in future installments
Less losses on istisna/reduction to cev
Add reversal of deferred profit
XX
(XX)
(XX)
(XX)
XX
12.6 Accounting Illustration
12.6 Accounting Problem
XYZ Islamic Bank entered into a two-year Istisna’ contract to construct a diesel power
generator for a total price of $600,000 commencing ! January 2002. The
following costs were estimated at the time of concluding the contract.
Materials
Wages
Total
31 December 2002
120,000
180,000
300,000
31 December 2003
60,000
120,000
180,000
Billings were made in tear 2002 for $225,000 and the remaining balance was billed
at the end of year 2003.
Following is the payment schedule that was agreed with the client of XYZ Islamic
Bank :
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Chapter 12: Accounting for Istisna’ and Parallel
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Year
2002
2003
2004
2005
2006
% of total price
10%
10%
20%
30%
30%
The XYZ Islamic Bank incurred general and administration expenses totalling $5,000
during 2002.
Substantial increase in material cost occurred in 2003 due to the liquidation of a major
supplier for the said material. Accordingly, the bank revised its cost estimate
for material to be $60,000 higher than previous planned.
The Bank recognises revenue based on the percentage of completion method.
Required :
Prepare all necessary journal entries for the years 2002 to 2006 to record the above
transactions in the books of XYZ Islamic Bank .
Prepare the statement of financial position and income statement of the XYZ Islamic
Bank for the year 2002 and 2003 to present the transactions relating to the
contract.
(A.I.A, Professional Examination II,2002,Q 1)
udarib.
Solution:
Journal entries for 2002
Dr. Istisna work in progress
300,000
Cr. Accounts payable / cash
(On account of materials 120,000 and wages 180,000)
Dr. General & admin. Expenses
Cr. Accounts payable / cash
300,000
5,000
5,000
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Dr.Istisna account receivable
Cr. Istisna billings
225,000
Dr.Cash
Cr. Istisna accounts receivable
60,000
Dr. Cost of istisna revenue
Dr. Istisna work in progress
Cr. Istisna revenue
300,000
75,000
225,000
60,000
375,000
Journal entries for 2003
Dr. Istisna work in progress
240,000
Cr. Accounts payable / cash
( On account of materials 120,000 and wages 120,000)
Dr.Istisna account receivable
Cr. Istisna billings
375,000
Dr.Cash
Cr. Istisna accounts receivable
60,000
Dr. Cost of istisna revenue
Cr. Istisna work in progress
Cr. Istisna revenue
240,000
240,000
375,000
60,000
15,000
225,000
Journal entries for 2004
Dr.Cash
Cr. Istisna accounts receivable
12,000
12,000
Journal entries for 2005
Dr.Cash
180,000
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Cr. Istisna accounts receivable
180,000
Journal entries for 2006
Dr.Cash
Cr. Istisna accounts receivable
180,000
180,000
b.
XYZ Islamic Bank
Statement of financial position as at 2002
2002
Istisna work in progress
Less istisna billings
375,000
225,000
150,000
165,000
Istisna accounts receivable
XYZ Islamic Bank
Statement of financial position as at 2003
2003
Istisna work in progress
Less istisna billings
600,000
600,000
-
Istisna accounts receivable
480,000
XYZ Islamic Bank
Income statement for the year ended 2002
2002
Istisna revenue
Istisna cost
General & admin expenses
375,000
300,000
75,000
5,000
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Istisna’
Net profit
70,000
XYZ Islamic Bank
Income statement for the year ended 2003
2003
Istisna revenue
istisna cost
225,000
240,000
(15,000)
Net Loss
CIPA Multiple Choice
Questions
1 . Zain Islamic Bank agreed to construct on an Istisna’ contract term, 25 semidetached luxury villas in the Topkapi Hillview estate for their client, Aksaray
Construction Company. Which statement identifies the correct parties to this
Istisna’ contract:
a) Topkapi Hillview estate is the seller (al-sani’) and Zain Islamic bank is the agent of the
purchaser (al-mustasni’).
b) The 25 semi detached villas is the asset (al-masnoo’) and Aksaray Construction Company is
the seller (al-sani’).
c) Topkapi Hillview estate is the purchaser (al-mustasni’) and Zain Islamic bank is the agent of
the seller (al-sani’).
d) Zain Islamic bank is the seller (al-sani’) and the Aksaray Construction Company is the
purchaser (al-mustasni’).
2. An Islamic Bank has agreed to construct a manufacturing facility for its customer
through an Istisna’ contract.
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The total contract price is US$ 1,700,000 while the contract cost is estimated at
US$ 800,000. Construction is estimated to be completed in 2 years.
By end of Year 1, the cumulative costs incurred were US$ 300,000 including precontract costs of US$ 45,000.
Assuming all these costs were paid off by cash, which of the following journal
entries are correct for Year 1:
a)
Dr
Istisna’ Work in progress
Cr
345,000
Cash
300,000
Deferred cost
45,000
b)
Dr
Istisna’ Work in progress
Cr
300,000
Cash
255,000
Deferred cost
45,000
c)
Dr
Istisna’ accounts receivable
Cr
300,000
Istisna’ work in progress
300,000
d)
Dr
Cash
Cr
345,000
Istisna’ Work in progress
300,000
Deferred cost
45,000
(CIPA sample questions)
3. The “Istisna’a” is explained by which of the following statement:
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a) Istisna’ is a contract of agency for specified items to be manufactured, with an obligation on
the part of the agent to ensure the manufacturer delivers the items to the customer.
b) Istisna’ is a contract of trust, between the manufacturer and the trustee, with an obligation on
the part of the trustee to sell the manufactured items in future.
c) Istisna’ is a contract of sale of specified items to be manufactured, with an obligation on the
part of the manufacturer to deliver them to the customer upon completion.
d) Istisna’ is a contract of partnership to manufacture specified items with an obligation on the
part of the manufacturer to deliver the items to the partners upon completion.
4. Zaid Islamic Finance agreed to construct on an Istisna’ contract term, a 25-storey
office building for their client, Ishaq Properties. The total contract price is
US$500,000 and is estimated to be completed in 24 months. The cumulative costs
incurred during Year 1 was US$300,000. Assuming all of these costs were paid off
by cash, which of the following journal entries are true?
a)
Dr
Istisna’ Work in progress
Cr
300,000
Cash
300,000
b)
Dr
Istisna’ Work in progress
Cr
500,000
Cash
300,000
Istisna’ billings
200,000
c)
Dr
Istisna’ accounts receivable
Istisna’ work in progress
d)
Cr
300,000
300,000
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Dr
Cash
Istisna’ Work in progress
Cr
300,000
300,000
5) Which of the following statements regarding the price of an Istisna’ asset is false?
a) The price should be known to the extent of removing lack of knowledge.
b) The price cannot be increased or decreased on account of the normal increase or decrease in
commodity prices or cost of labour.
c) The price may be changed by the mutual consent of the contracting parties due to unforeseen
contingencies such as modifications required to the construction.
d) All of the above is false.
Q3-5 are from CIPA July 2006 examinations
Question 12-1
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Chapter 12: Accounting for Istisna’ and Parallel
Istisna’
Discuss the applicability and limitations of Salam and Istisna’a’ financing in
adapting into a modern financial environment.
(IIUM B.Acc, semester 2, 2002/2003, Q3b)
Question 12-2
a. Compare and contrast the similarities and differences betweem
salam financing and istisna’a’ financing;
b. Explain the possible reasons why salam and istisna’a’ financing
are not widely practiced by financial institutions in Malaysia; and,
c.
Illustrate with a simple example the parallel istisna’a’ financing
and show how istisna’a’ revenue and profit is recognized as
recommended by AAOIFI’s Financial Accounting Standard No.10.
(IIUM B.Acc, Resit semester 3, 2002/2003,
Q3)
Question 12-3
i. RHB Islamic Bank Islamic entered into a 4 year Istisna’a contract with
the Malaysian government to build a bridge over the PutraJaya river at
$100 million and payable by the Malaysian government as follows:
On signing of contract
End of 1st year
End of 2nd year
End of 3rd year
End of 4th year
10%
20%
20%
30%
20%
The bank billed the Malaysian government on schedule and the
government paid promptly.
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The istisna’a contract stipulated any increase in costs will be borne by the
bank and will not be passed on to the government. However, the
government would not charge any penalty for late completion of up to a
year.
At the same time, RHB Islamic Bank entered into a parallel Istisna’a contract
worth $80 million with Islamic Engineers Malaysia to build, test and hand
over the bridge over a two year period. Islamic Engineers did not agree to
bear any additional cost over run. The bank agreed to pay Islamic Engineers
a 10% initial payment on the signing of the contract. Subsequent payments
by the bank would be in 30 days after each progress billing was made to the
bank.
In the first year, Islamic engineers billed $32 million to the bank. In the
second year however, costs escalated and Islamic Engineers informed the
bank that it would cost an additional $ 25 million to complete the bridge
and required an extension of 6 months. They billed the bank another
$50million during the second year.
In the third year, Islamic engineers completed the bridge. However, the
actual costs had only gone up by $20 million and Islamic Engineers agreed
to pay a penalty of $ 5 million according to the istisna’a contract for late
completion. The SSB of RHB Islamic had established that any late payments
by sub contractors was not considered as riba and to be taken as revenue of
the bank. Islamic Engineers billed the bank the remaining amount during
the third year and was paid accordingly in the same year.
Required:
Journal entries in the books of RHB Islamic Bank for the above transactions
from year 1 to 4 if profits are recognized on an (a) accrual basis and (b) end
of contract basis.
( IIUM MBA, 2005/2006, Q5b )
Question 12-4
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Chapter 12: Accounting for Istisna’ and Parallel
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A.
Dubai Investment House (DIH) , an Islamic bank signed an Istisna’a contract
with Malaysian Nuclear Agency (MNA) on 1 Jan 2006 to build and deliver
a nuclear reactor for $300 Million on 31st December 2007. MNA would pay
10% of the contract price on the signing of the contract to DIH and DIH
would bill MNA for the remaining amount of the contract as per the
following schedule:
31 /12/2006
31/12/2007
31/12/2008
31/12/2009
20%
30%
20%
20%
MNA would not accept any cost escalation but would not charge DIH any
penalty if the reactor was delayed NOT beyond 1 year from the schedule
delivery date of 31st December 2007. DIH billed MNA per the above
schedule and was paid on 31st January in the year following the billing date.
At the same date(1/1/2006) , Dubai Investment House signed a parallel
istisna’a contract with Nucleon, a engineering firm in France who
specialized in building nuclear reactors for $200M with the following terms
of payment:
On signing the contract
10% of contract price
Further amounts to be paid on billings by Nucleon.
Nucleon agreed to deliver the reactor on 31st December 2007 failing which
DIH would charge Nucleon a penalty of 10% per annum of the contract
price on a prorata basis based on time. Nucleon refused to bear any cost
escalation. It would simply pass on the costs to DIH.
The following billings were made by Nucleon to DIH and DIH paid
Nucleon in 60 days after the billing date
30th November 2006
$80M
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In February 2007, Nucleon informed DIH that the cost of the reactor had
escalated and it would now cost $320 Million and delivery would be
delayed until 30 Jun 2008. It billed DIH another $200M on 1st November
2007, which DIH paid in 31st January 2008. In Jun 2008, Nucleon delivered
the completed reactor. Nucleon billed the remaining costs of the contract
less the penalty it had to pay on 30 Jun 2008 and was paid by DIH 60 days
thereafter.
(i)
(ii)
Required:
Provide the necessary T accounts (NOT journal entries) in the books of
DIH for the contract from 1st January 2006 until the final payment was
settled by MNA assuming DIH uses the percentage of completion method
to calculate profits.
An extract of the Income statements and Balance Sheet for the necessary
years.
(IIUM B.Acc, semester 1, 2006/2007, Q1a)
B.
Would you prefer a BBA or a Istisna’a contract from an Islamic bank to
finance an unfinished home? Why? Explain another Islamic contract that
can be used to finance a house other than murabaha with ultimate
ownership transferred to you?
(IIUM B.Acc, semester 1, 2006/2007, Q1c)
Question 12-5
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Chapter 12: Accounting for Istisna’ and Parallel
Istisna’
AmBank Islamic entered into a 4 year Istisna’a contract with the Malaysian
government to build a bridge over the Kelang river at $100 million
and payable by the Malaysian government as follows:
On signing of contract
End of 1st year
2nd year
End of 3rd year
End of 4th year
10%
20%
20%
30%
20%
The bank billed the Malaysian government on schedule and the
government paid promptly.
The istisna’a contract stipulated any increase in costs will be borne by the
bank and will not be passed on to the government. However, the
government would not charge any penalty for late completion of up to a
year.
At the same time, AmBank Islamic entered into a parallel Istisna’a contract
worth $80 million with United Engineers Malaysia to build, test and hand
over the bridge over a two year period. United Engineers did not agree to
bear any additional cost over run. The bank agreed to pay United Engineers
a 10% initial payment on the signing of the contract. Subsequent payments
by the bank would be in 30 days after each progress billing was made to the
bank.
In the first year, United engineers billed $32 million to the bank. In the
second year however, costs escalated and United Engineers informed the
bank that it would cost an additional $ 25 million to complete the bridge
and required an extension of 6 months. They billed the bank another
$50million during the second year.
In the third year, united engineers completed the bridge. However, the
actual costs had only gone up by $20 million and United Engineers agreed
to pay a penalty of $ 5 million according to the istisna’a contract for late
completion. The SSB of AmBank Islamic had established that any late
payments by sub contractors was not considered as riba and to be taken as
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Chapter 12: Accounting for Istisna’ and Parallel
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revenue of the bank. UEM billed the bank the remaining amount during the
third year and was paid accordingly in the same year.
Required:
Journal entries in the books of AmBank Islamic for the above transactions
from year 1 to 4 if profits are recognized on an (i) accrual basis and (ii) end
of contract basis.
(IIUM B.Acc, semester 2, 2005/2006, Q6c)
Question 12-6
In the year 2006, the Islamic Development Bank of Brunei (IDBB) entered
into an Istisna’a’a contract with Malaysian government to build and deliver
a highway project at $15 million in three years time, to be delivered at the
end of year 2008. The bank billed Malaysian government as follows:
On signing of contract
End of year 2006
End of year 2007
End of year 2008
End of year 2009
10%
30%
20%
20%
20%
The government paid the bank one month after the billing date.
The Istisna’a’a contract clearly indicated that any increase in costs will be
borne by the bank and will not be paid by the government. However, the
government agreed not to charge any penalty if the bank is able to deliver
within 6 months after the due delivery date.
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The bank immediately entered into parallel Istisna’a’a contract at $12
million with Plus Berhad to build the highway project according to the
Malaysian government’s specifications. Plus Berhad did not agree to bear
any additional cost over run. However, if Plus Berhad did not deliver the
project on the due date, it was agreed that the bank will charge a penalty of
5% of the total costs at pro rata basis and the penalty was paid to the
charity.
The bank agreed to pay Plus Berhad a 10% initial payment on the signing of
the contract. Subsequent payments by the bank would be two months after
each billing was made to the bank. The payments made by Plus Berhad
during the first two years are as follows:
Year 2006
Year 2007
$4.5 million
$4.0 million
In year 2008, the total costs were anticipated to increase to $16 million and
Plus Berhad informed the bank that they required an extension of six
months. They billed the bank $4 million during the year 2008.
In July 2009, Plus Berhad completed the highway. However, the actual costs
has only increased to $14 million. Plus Berhad billed the bank the remaining
amount during year 2009 and was paid accordingly in the same year.
Required:
a. Ledger entries in the books of Islamic Development Bank of Brunei for
the above transactions from year 2006 to year 2009 if profits are
recognised based on percentage of completion method.
b. An extract of the income statement and Balance Sheet for the necessary
years.
(IIUM B.Acc, semester 2, 2006/2007, Q2)
Question 12-7
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Chapter 12: Accounting for Istisna’ and Parallel
Istisna’
1. Copy the table below to your answer book and complete the table
showing the similarities and differences between salam and istisna’a
contracts.
2. Bank Salim Bhd. Entered into a contract with Selangor Airlines to
manufacture and deliver 2 state of the art passenger jet aircraft for
$100 Million over the next two years.
Subject
Salam
Istisna’a
Rules and
Comments
Seller
Buyer
Subject Matter of the
contract
When Price is paid
Parallel
Contract
The contract called for billings and payments to be made by the end of
the each financial year which coincided with the contract. At the same
time Bank Salim entered into a parallel istisna’a agreement with
Malaysian Airperahu Industries to buy the two aircraft for $80 million
deliverable in the two years.
The other details of the transactions are as follows:
Transaction
Billings by Bank Salim to Selangor Airlines
Year 1
$40m
Year 2
$60M
Billings by AirPerahu to Bank Salim
$30M
$50M
Payments to Malaysian Airperahu
Collections from Selangor Airlines
$25M
$ 35M
$55M
$65M
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Chapter 12: Accounting for Istisna’ and Parallel
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Assuming the bank used the percentage of completion method,
prepare journal entries for the above as well as show the extracts of the
income statements and the balance sheets for year 1 and year 2 in the
books of the Bank Salim Bhd
(IIUM B.Acc, semester 2, 2004/2005, Q5 b & c)