Chapter Two

Musharraka

LEARNING OBJECTIVES
LEARNING OBJECTIVES
After Going through this chapter, you should be able to:
1. Describe the nature of a Musharraka Contract.
2. Understand how Musharraka Capital is recognized in financial Statements
3. Describe the subsequent accounting treatment for Musharraka Capital
4. Understand how Islamic Banks’s share in Musharraka profit and loss is recorded
5. Describe presentation and disclosure requirements of FAS 4 for Musharraka
6. Describe how Musharraka Capital is initially recognized and subsequently measured
under IFRS.
7. Understand how Islamic Bank’s share in Musharraka profit and loss is recorded.
1 Chapter One Murabaha and Murabaha to the Purchase Orderer

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Musharraka

Nature & Types Accounting Treatment

Recognition of Subsequent
Measurment Presentation &
Musharraka Musharraka Diclosure
&Liquidation
Types of Musharraka
-Diminishing Musharraka - Profit
-Constant Musharraka Recognition
- Liquidation

2.1 Muharraka and its Types

Consider Hassan, who is planning to start a small garment manufacturing business in the suburbs
of Riyadh. As per Hassan's estimate, he has to buy assets worth $30,000, inventory worth
$7,000, and has to have liquid cash of $3,000 for starting this business. Hence, the total
estimated amount required for starting the business is $40,000. Hassan has estimated that he can
manage to invest $20,000 from his personal savings. Hassan has two options either he can
acquire equity financing in the form of Musharaka from an Islamic bank or can acquire debt
financing from a conventional financing institution. Each of these two options has its own
benefits and associated risks.

Let us consider the case in which Hassan goes to a conventional bank to acquire financing for his
new venture. The bank has offered to lend to Hassan $20,000 at an annual interest rate of 10%.
Hassan will have to return the principal amount in a lumpsum payment at the end of 10 years.
There are some important benefits for Hassan for participating in such an arrangement. Hassan
can accurately calculate the amount of money that he will have to pay to the bank at the end of
each year. If Hassan can generate higher returns on his assets than the borrowing cost, then he
can significantly increase his profit. Similarly, there are some crucial benefits of such an
arrangement for a financing institution. The bank can calculate the future cash inflows for this
contract with a great deal of certainty.

However, participating in such an arrangement introduces an element of financial leverage in the

business and can significantly increase the financial risk of the business. Consider the following
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table that shows how, in the case of a leveraged business, Hassan's profit will be affected by
changes in the changes in return on assets.

Scenario Analysis for a Leverage Firm

Scenario A B C
Return on Assets (ROI) 5% 10% 15%
Profit before Interest $2,000 $4,000 $6,000
Interest Payment $2,000 $2,000 $2,000
Profit After Interest $0 $2,000 $4,000
Net Profit (%) 0% 10% 20%

The table shows that changes in return on asset (ROI) have magnified effects on Hassan's profit
for this business. It is because of the fact that Hassan has to earn a return on the assets which is
equal to the cost of the borrowing. Otherwise, his net percentage profit will become less than the
return on the assets (ROI).

Now consider the case in which Hassan opts for equity financing from an Islamic bank. After
careful consideration of Hassan's business proposal, an Islamic bank has agreed to provide him
an equity financing of $20,000. Hassan and the Islamic bank have agreed that Hassan will be
responsible for managing the business and will have a right over 50% of total profit. The Islamic
bank will also get 50% of the total profit of the business. In case of a loss, the loss will be shared
between Hassan and the Islamic bank, according to their shares of equity capital. There are some
distinct disadvantages to this arrangement for Hassan. Hassan can't hope to increase his net
percentage profit beyond the return on assets. While the Islamic bank will face greater
uncertainty in calculating its future cash inflows from this contract. The following table shows
the relationship between the return on assets, Hassan's profit, and the Islamic bank's profit.

Scenario Analysis for Musharrak financing

Scenario A B C
Return on Assets (ROI) 5% 10% 15%
Total Profit $2,000 $4,000 $6,000
Bank’s share of Profit $1000 $2,000 $3000
Hasan’s share of Profit $1000 $2,000 $3000
Hassan’s Profit (%) 5% 10% 15%

As the table shows, in the case of equity financing, Hassan cannot take advantage of the
magnifying effect of changes in return on assets on the net profit. However, now Hassan does not
have to meet a threshold return on assets (ROI), equal to the borrowing cost, to keep his
3 Chapter One Murabaha and Murabaha to the Purchase Orderer

percentage return above or equal to the return on assets (ROI). In the previous case of debt
financing, the bank was getting a fixed return on the amount lent to the customer but could not
take advantage of fluctuations in return on assets. In the case of equity financing, the bank does
not get a fixed return, but can its return increases when the return on assets goes up. However, in
this case, the bank will also share the business losses, and its return can go significantly lower
than the usual lending rate for projects of similar risk profile.

There are some significant differences between the debt financing and the equity financing or
partnership. In the case of debt financing, the lender requires a fixed return from the borrower.
This return can be fixed in amount or can be based on a fixed benchmark. However, in case of
the equity financing, the return of the financier is fixed neither in amount nor it is based on a
fixed benchmark. The creditor is never required to share the losses of the business and can hold
the borrower responsible for not providing a particular return to the creditor on borrowed funds.
On the other side, an equity holder always shares in the losses of the business and cannot hold
other equity holders responsible for not generating a particular amount of return on the invested
capital. In normal circumstances, a creditor does not participate in the management of the
venture. While participants in an equity partnership usually have the right to participate in the
management of the business. However, usually not all the equity holders participate in managing
a business, and a small number of them take all the decisions related to managing the business.

In Islamic finance, such equity financing is called Musharaka. The word Musharaka in Arabic is
a derivative from the root word Sharika or to share (Alamad 2019). AAOIFI equates the modern
Musharaka with the classical contractual partnership, which is known as sharikat al-‘aqd
(Alamad 2019). AAOIFI’s Shariah Standard No. 12 defines a contractual partnership (and thus a
Musharaka) as a partnership “between two or more parties whereby each partner contributes a
specific amount of money in a manner that gives each one a right to deal in the assets of the
partnership, on condition that the profit is distributed according to the partnership agreement and
that the losses are borne in accordance with the contribution of each partner to the capital.”

There are two types of Musharaka:

1): Constant Musharaka
2): Diminishing Musharaka.

In a Constant Musharaka, the partners’ shares in the capital remain constant throughout the
period of partnership, as specified in the contract. For example, two parties decide to invest in a
4 Chapter One Murabaha and Murabaha to the Purchase Orderer

startup business. Party A will invest $600,000, and Party B will invest $400,000. Party A is the
owner of 60% equity of this venture, while Party B is the owner of 40% equity. Suppose, Party
B is more actively engaged in the management of the business. So, the agreed-upon profit-
sharing ratio between both parties is 50% each. In this agreement, the two partners' equity
ownership ratio will remain constant over the partnership period.

In a Diminishing Musharaka, the Islamic bank agrees to transfer gradually to the other partner its
share in the Musharaka, 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. Consider a Musharaka
contract, in which two parties have decided to construct a commercial plaza. Party A will invest
$1,300,000, and Party B will invest $700,000. Both parties agreed that profit and loss would be
shared in the proportion of the equity each partner holds. However, party A also agreed to
purchase the equity share of party B over a period of 7 years. At the end of each year, Party A
will make a payment of $100,000 to acquire 1/7th of the original equity share of Party B. The
following table shows the transfer of equity from Party B to Party A.

Equity Share Equity Share of Percentage Equity Percentage Equity

of Party A Party B Share of Party A Share of Party B
Start of $1,300,000 $700,000 65% 35%
Year 1
End of $1,400,000 $600,000 70% 30%
Year 1
End of $1,500,000 $500,000 75% 25%
Year 2
End of $1,600,000 $400,000 80% 20%
Year 3
End of $1,700,000 $300,000 85% 15%
Year 4
End of $1,800,000 $200,000 90% 10%
Year 5
End of $1,900,000 $100,000 95% 5%
Year 6
End of $2,000,000 $0 100% 0%
Year 7

For profit-sharing, the percentage at the start of the period will be used. The following table
shows the change in the profit-sharing ratio of Party A and Party B.

Percentage Percentage Equity Party A’s share of Party B’s share of

Equity Share Share of Party B profit profit
of Party A
Start of 65% 35% - -
Year 1
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End of 70% 30% 65% 35%

Year 1
End of 75% 25% 70% 30%
Year 2
End of 80% 20% 75% 25%
Year 3
End of 85% 15% 80% 20%
Year 4
End of 90% 10% 85% 15%
Year 5
End of 95% 5% 90% 10%
Year 6
End of 100% 0% 95% 5%
Year 7
End of 100% 0% 100% 0%
Year 8

Concept Check
Identify which of the following five statements are true or false. If a statement is false, indicate why
this statement is false:
1) Debt financing introduces an element of leverage in the business.
2) An institution that provides the equity financing is never responsible for losses of the business.
3) In a Musharraka losses are shared in same proportion as the profits of the business.
4) In a Constant Muharraka, the profit-sharing ratio remain constant. But the equity shares of partners
can change
5) In a Diminishing Muharraka, the equity share of one partner is transferred completely to another
over a fixed period.

Solution:
1) True.
2) False.
The institution that provides the equity financing becomes an equity holder of the business.
Hence, it takes on all the responsibilities of an equity holders. One those responsibilities is
to share in the losses of the business.
3) False.
In a Musharraka losses are not shared in same proportion as the profits of the
business. Losses, in a Musharraka contract, are always shared among the partners
according to their share of the equity capital.
4) False.
In a Constant Muharraka, the profit-sharing ratio can change. But the equity shares of
partners always remain constant.
5) True.
6 Chapter One Murabaha and Murabaha to the Purchase Orderer

Session Summary:
 The fundamental difference between a Musharraka and a conventional debt financing
agreement is charging of the return. A conventional debt financing agreement requires the
borrower to provide a fixed return to the creditor. While, in a Musharraka, the return of the
creditors fluctuates in accordance with changes in return on assets (ROI).
 A Musharraka is a partnership between two or more parties whereby each partner
contributes a specific amount of money in a manner that gives each one a right to deal
in the assets of the partnership, on condition that the profit is distributed according to
the partnership agreement and that the losses are borne in accordance with the
contribution of each partner to the capital.
 There are two types of Musharaka: Constant Musharaka and Diminishing Musharaka.
 In a Constant Musharaka, the partners’ shares in the capital remain constant throughout the
period of partnership, as specified in the contract
 In a Diminishing Musharaka, the Islamic bank agrees to transfer gradually to the other partner
its share in the Musharaka, 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.

In Musharaka, the partnership can be concluded between two or more parties. However, there are
certain limitations concerning who can and who cannot enter into a partnership contract. A
Musharraka requires that each partner should be able to act as an agent for every other person in
the partnership. So, a person should have all the qualities that are required to be an agent. As
regards individuals, it is unanimously agreed that they should be free and of sound mind. There
are certain individual qualities and attributes that can deem a person permanently or temporarily
ineffective for entering into a partnership contract. Insane persons and minors cannot be partners
in a Musharaka contract. Similarly, a person who has lost the power to make decisions because
of a temporary condition also cannot enter into a Musharaka contract. Intoxication can be one
such condition (Ayub 2007).

In Musharaka, the capital must be contributed by all partners. Capital can be in the form of
monetary assets or in the form of tangible assets. However, for tangible assets, their cash-
equivalent value should be calculated. It can be contributed in a lump sum or in various
installments, even in different currencies. Using debt alone as the capital to the partnership is not
permitted, except to the condition when it becomes inseparable (Alamad 2019). Neither partner
can guarantee the other partner’s capital, because Musharraka is based on the principle that the
entitlement to return is related to the exposure to the risk. However, a partner may request
another partner to provide guarantees against the latter’s negligence or misconduct (FAS4
Appendix B, 2016). Musharakah can be concluded with non-Muslims and also interest-based
7 Chapter One Murabaha and Murabaha to the Purchase Orderer

banks to carry out operations acceptable in the Shariah. In this respect, the arrangement has to be
made to obtain all necessary assurances and guarantees that the rules and principles of Shariah
will be observed during the operation of the partnership. It excludes all those businesses which
are not lawful in Islam, i.e., trade-in swine flesh or liquor, etc. and unlawful activities like
pornography and gambling (Ayub 2007).

The proportion of profit to be distributed between or among partners must be agreed upon at the
time of effecting the contract. The profit-sharing ratio can be one other than the capital
contribution ratio, but cannot be a lump sum or a percentage of capital. It is allowed to a
particular partner a share in profit higher than his/her share in the capital. It is, however, not
permitted to defer the determination of the profit percentage owing to each partner until the
realization of profit. As for the procedure to calculate profit, partners can adopt either a
permanent or varying method. For example, by agreeing that the percentage of profit shares in
the first period are one set of percentages and in the second period are another set, or by using
any other method for the calculation and allocation of profit. Even profit sharing between the
partners can be done in a condition where the profit realized is above a particular ceiling; the
profit above such a ceiling will belong to a particular partner (Marifa 2014). In practice, such an
arrangement is called an “incentive fee” for the management of the pooled funds. The effect is
that the other partners will get (at best) a predetermined return on their invested capital, while
extra profits are appropriated by the managing partner (Ali 2012). So, the partners can divide the
partnership's profit in any manner that seems fit to them. Islamic jurists are unanimous on the
point that proportions of losses borne by partners must be equal to the proportions of their capital
contributions (Marifa 2014).

Suppose Umer and Hassan started a garments business in the suburbs of Lahore. They started
this business by forming a Musharraka partnership with a local Islamic bank. Both Umer and
Hassan contributed $15,000 each to the capital, and the Islamic bank invested $20,000 in the
business. Both Umer and Hassan hold 30% each the capital of the partnership. The islamic bank
contributed 40% capital of the partnership. It was decided between the three partners that Umer
and Hassan will be responsible for managing the business. While the Islamic bank will act as a
passive investor. It was decided between the partners that each of the active partners will have a
right to 40% of the profit of the firm. The Islamic bank will have a right to 20% of the total profit
of the firm. In the first year of operations, the business generated $20,000 in profit. This profit
8 Chapter One Murabaha and Murabaha to the Purchase Orderer

will be distributed between the partners according to the initially agreed profit-sharing ratios.
The following table shows the distribution of profit between the partners.

Profit Sharing between the Partners

Total Profit = $20,000
Umer Hassan Islamic Bank
% share of Profit 40% 40% 20%
Profit Share $8,000 $8,000 $4,000

In the 2nd year of operations, the business generated a net loss of $10,000. This net loss has to be
shared between the partners according to their respective contributions to the capital of the
business. The following table shows the distribution of loss between the partners.

Loss Sharing between the Partners

Total Loss = $10,000
Umer Hassan Islamic Bank
% share of Capital 30% 30% 40%
Loss Share $3,000 $3,000 $4,000

In Musharaka, all partners have equal right to take part in the management of the partnership.
However, the management of partnership can be restricted to specific partners or to a single
partner, in which case other partners are not allowed to act on behalf of the partnership. Some or
one of the partners can be appointed as a manager on the basis of an independent contract other
than the Musharaka and can be paid remuneration. A manager other than the partners can also be
appointed and can be paid a fixed remuneration. Each partner acts on behalf of himself and as an
agent for his partners. Hence, each partner is subject to the Shariah rules of the agency. In
particular, he must not act against the interests of the others. No partner can be denied his right to
work for the Musharaka (to participate in the management) by the others, but not all partners
must exercise their right with the same intensity. A partner who is particularly active in the
management can claim an additional profit share. In practice, banks that have co-financed
Musharaka projects usually did not get actively involved in the management as long as the
project's performance did not fall short of particular benchmarks (Alamad 2019).

The partners may appoint workers to perform tasks which are nit within the scope of their
individual work, and the cost of such work will be borne by the partnership. However, if a
partner employs a worker to do some of the tasks which were originally assigned to him, the
9 Chapter One Murabaha and Murabaha to the Purchase Orderer

resulting costs will be borne by him since the partnership contract is based on both the funds and
the work, and the earned profits are the outcome of both elements. Appointment of the workers is
conditional upon a genuine requirement of their services and that they should receive
remuneration in accordance with this (FAS4 Appendix B, 2016).

Consider the example that we have discussed above of Umer and Hassan forming a Musharraka
partnership with an Islamic bank to start a garments business. In that example, both Umer and
Hassan contributed $15,000 each to the capital of the business. While the Islamic contributed
$20,000. So, both Hassan and Umer contributed 30% each to the capital of the business, and the
Islamic bank contributed 40% of the capital. However, the profit-sharing ratio was quite
different. 40% share of the profit was assigned each to Umer and to Hassan. While the Islamic
bank was assigned only 20% of the total profit. It was certainly because of the fact that both
Umer and Hassan were responsible for managing the business. While the Islamic bank had to act
as a passive investor. However, it is to be noted that this profit-sharing ratio cannot be used to
distribute the business losses between the partners. It seems like a serious departure from the
conventional thinking. In Musharraka, the losses of the business will always be shared between
the partners in accordance with their shares in the capital of the business. So, in this example, in
case of a net loss, 40% of the loss will always be borne by the Islamic bank because it has
contributed 40% of the capital. While 30% of the loss will be allocated to the Umer and Hassan
each.

In general, the partnership shall be terminated of one of the partners terminates the contract, or
dies, if his legal competency ceases or if the partnership capital is lost (FAS4 Appendix B,
2016). Each partner has a right to terminate the Musharaka after giving due notice. Partners can
enter into a binding promise to continue the partnership for a period of time. In case of maturity,
assets can be distributed in a fixed proportion between or among partners. If this is not possible,
one of the partners can buy all the assets per their market value (not on face value) and pay the
proceeds to others. A Musharaka can also come to an end on the expiry date or as per the
agreement of partners to terminate prematurely, or in case of death or incapacity of a partner
(Sadique 2009). In the case of the death, one of the heirs, if he is of sound mind, may replace the
deceased provided that other heirs and the other partners agree to that. This shall also be
applicable in case one the partners loses competency (FAS4 Appendix B, 2016).
10 Chapter One Murabaha and Murabaha to the Purchase Orderer

Concept Check
Identify which of the following five statements are true or false. If a statement is false, indicate why
this statement is false:
1) In order to enter into a Musharraka contract, a person should have the qualities to act as an agent.
2) The capital contributed to the Musharraka should always in the form a currency or a liquid asset.
3) In a Musharraka losses are shared in same proportion as the profits of the business.
4) In Muharraka, all the partners have a binding right to work on behalf of the partnership.
5) In Muharraka, the profit-sharing ratio should always be equal to the capital contribution ratio of the
partners.

Solution:
1. True.
2. False.
Capital can be in the form of monetary assets or in the form of tangible assets. However, for
tangible assets, their cash-equivalent value should be calculated.
3. False.
In a Musharraka losses are not shared in same proportion as the profits of the business.
Losses, in a Musharraka contract, are always shared among the partners according to
their share of the equity capital.
4. False.
In Musharaka, all partners have equal right to take part in the management of the partnership.
However, the management of partnership can be restricted to specific partners or to a single
partner, in which case other partners are not allowed to act on behalf of the partnership.
5. False.
In a Musharraka, the profit sharing ratio is not always required to be equal to the capital
contribution ratio of the partners. Partners can divide the partnership's profit in any manner that
seems fit to them.

Session Summary:
 In Musharaka, the partnership can be concluded between two or more parties. However, there
are certain limitations concerning who can and who cannot enter into a partnership contract. A
Musharraka requires that each partner should be able to act as an agent for every other person
in the partnership. So, a person should have all the qualities that are required to be an agent.
 In Musharaka, the capital must be contributed by all partners. Capital can be in the form of
monetary assets or in the form of tangible assets. However, for tangible assets, their cash-
equivalent value should be calculated. It can be contributed in a lump sum or in various
instalments, even in different currencies.
 The proportion of profit to be distributed between or among partners must be agreed upon at
the time of effecting the contract. The profit-sharing ratio can be one other than the capital
contribution ratio, but cannot be a lump sum or a percentage of capital. It is allowed to a
particular partner a share in profit higher than his/her share in the capital.
 In a Musharraka, the proportions of losses borne by partners must be equal to the proportions
of their capital contributions.
 In Musharaka, all partners have equal right to take part in the management of the partnership.
11 Chapter One Murabaha and Murabaha to the Purchase Orderer

However, the management of partnership can be restricted to specific partners or to a single

partner, in which case other partners are not allowed to act on behalf of the partnership.
 Each partner has a right to terminate the Musharaka after giving due notice. Partners can enter
into a binding promise to continue the partnership for a period of time. In case of maturity,
assets can be distributed in a fixed proportion between or among partners.

2.2 Accounting Treatment

The accounting treatment discussed below is as per the requirements of Financial Accounting
Standard No 4. This standard applies to all Musharraka transactions and lays down the basis for
determination of accounting treatment for initial recognition of the Musharraka contract and
related revenues, expenses, gains and losses attributable to the Musharraka contract. This
standard also advises the accounting treatment of subsequent measurement of the Musharraka
capital and its liquidation.

2.2.1 Initial recognition and measurement of Musharraka

Recognition of Musharraka Capital

Initial recognition of Musharraka capital is similar for both types of Musharraka contracts i.e. Constant
Musharraka and Diminishing Musharraka. An Islamic bank should recognize the Musharraka financing
capital when it is made available to the client (who is also the partner in the Musharraka contract). It
means that when the funds has been paid to the client or has been made available on account to the client.
In case of a single payment, Musharraka capital should be recognized when case is paid or funds are
transferred to client. In case of instalments then each instalment shall be recognized at the time of its
payment.

Illustration1.1
ABC Islamic bank agreed on January 1, 20XX to provide finance to the client through a Musharraka
contract. After completion of formal process and documentation, on January 25, 20XX, the bank
processed the transfer of funds to client’s account. The funds successfully transferred to the client’s
account on February 1, 20XX.
In this case, the funds were effectively made available to the customer on February 1, 20XX.
So, ABC Islamic bank should recognize the Musharraka capital on February 1, 20XX.

Measurement of the Musharraka Capital

Islamic bank should measure the Musharraka capital paid in cash or made available to the
customer on account at the face value of cash paid. However, if all or part of the fund in kind,
12 Chapter One Murabaha and Murabaha to the Purchase Orderer

e.g. trading assets or non-montary assets for use in the venture, such assets should usually be
measured at their fair value. However, the bank can also measure these assets at value agreed
between the bank and the client.

Illustration 1.2
ABC Islamic provided $100,000 in cash and a commercial apartment as Musharraka capital
for investment in real estate project. Both of the parties agreed the value of the apartment at
$300,000. The funds and the apartment were effectively transfer to the client on February 3,
20XX.
The Islamic bank should recognize the Musharraka capital at a value equal to the cash funds
transferred to the Musharraka and the agreed value of the apartment. The accounting entry
will be:
Date Description Dr. Cr.
Feb 3, 20XX Musharraka Capital $400,000
Cash Account $100,000
Office Apartment $300,000

In case of funds in kind, it is usually possible that the value agreed between the client and the
bank is different from the book value of the asset. In a case, where the asset has been recognized
at the value agreed between the client and the bank, the difference between value agreed and the
book value of the asset will be recognized in the profit and loss account for the period.

Illustration 1.3
ABC Islamic transferred a commercial plot to its customer under Musharraka financing. The
bank had purchased this property last year at $100,000 and was reporting it in its financial
statements using historical cost method. Both of the parties agreed the value of the property
for the purpose of the Musharaka will be $175,000. The apartment was effectively transfer to
the client on February 3, 20XX.
The Islamic bank should recognize the Musharaka capital at the value agreed with the
customer. The accounting entry will be:
Date Description Dr. Cr.
Feb 3, 20XX Musharraka Capital $175,000
Office Apartment $175,000

The bank will record the difference between its book value and agreed value as gain in the
profit and loss account. The accounting entry will be:
Date Description Dr. Cr.
Feb 3, 20XX Office Apartment $75,000
Gain – Profit and loss account $75,000
13 Chapter One Murabaha and Murabaha to the Purchase Orderer

Both of the parties may incur some expenses in the pre-Musharraka period that are related to the
Musharraka. These expenses should not be included in the Musharraka capital rather should be
charged to profit and loss account of the respective entity. However, if it is agreed between both
parties, these expenses can be added to the Musharraka capital.

Illustration 1.4
ABC Islamic hired a consultant to conduct a feasibility study of a commercial plaza to
evaluate the profitability of the project proposed by a client. It paid $40,000 to the consultant.
Both parties agreed that the bank can add this amount to Musharraka capital. Bank provided
$760,000 under the Musharka financing contract on January, 03 20XX. The Islamic bank
should recognize the Musharraka capital with the total of funds delivered and the cost
incurred in this respect. The accounting entry will be:
Date Description Dr. Cr.
Feb 3, 20XX Musharraka Capital $800,000
Cash Account $760,000
Cash Account (consultancy expense) $40,000
14 Chapter One Murabaha and Murabaha to the Purchase Orderer

Concept Check
Identify which of the following five statements are true or false. If a statement is false, indicate why
this statement is false:
1) Musharraka capital is recognized when the bank expresses its intention to provide Musharraka
financing to a client.
2) Initially Musharraka capital is recognized at the face value of the funds provided to the client.
3) If the Musharraka financing is provide in kind, i.e. some tangible asset other than cash, then
Musharraka capital is always recognized at the book value of the asset provided.
4) In Muharraka, if the book value of the asset and value at which Musharaka capital is recognized is
different. Then, the different is capitalized by the bank.
5) In Muharraka, both of the parties may incur some expenses in the pre-Musharraka period that are
related to the Musharraka. These expenses should always be charged to profit and loss account of the
respective entity.

Solution:
1. False.
An Islamic bank should recognize the Musharraka financing capital when it is made available to
the client (who is also the partner in the Musharraka contract). It means that when the funds has
been paid to the client or has been made available on account to the client.
2. True.
3. False.
In case of funds in kind, it is usually possible that the value agreed between the client and the
bank is different from the book value of the asset. In a case, where the asset has been recognized
at the value agreed between the client and the bank, the difference between value agreed and the
book value of the asset will be recognized in the profit and loss account for the period.
4. False.
In a case, where the asset has been recognized at the value agreed between the client and the
bank, the difference between value agreed and the book value of the asset will be recognized in
the profit and loss account for the period.
5. False.
Generally, there expenses are charged to the profit and loss by the bank and by the client.
However, the bank and the client can decide to make expenses part of the Musharraka capital.

Session Summary:
 An Islamic bank should recognize the Musharraka financing capital when the funds has been
paid to the client or has been made available on account to the client. In case of a single
payment, Musharraka capital should be recognized when case is paid or funds are transferred
to client. In case of instalments then each instalment shall be recognized at the time of its
payment.
 Islamic bank should measure the Musharraka capital paid in cash or made available to the
customer on account at the face value of cash paid. However, if all or part of the fund in kind,
such assets should usually be measured at their fair value. However, the bank can also measure
these assets at value agreed between the bank and the client.
 In a case, where the asset has been recognized at the value agreed between the client and the
bank, the difference between value agreed and the book value of the asset will be recognized in
15 Chapter One Murabaha and Murabaha to the Purchase Orderer

the profit and loss account for the period.

 Both of the parties may incur some expenses in the pre-Musharraka period that are related to
the Musharraka. These expenses should not be included in the Musharraka capital rather
should be charged to profit and loss account of the respective entity. However, if it is agreed
between both parties, these expenses can be added to the Musharraka capital.

2.2.2 Subsequent Measurement of Musharraka Capital

Year-end Measurement of Musharaka Capital
The subsequent measurement differ for the Constant Musharrka and the Diminishing
Musharraka. In case of a constant Musharraka, Islamic bank should continue to recognize the
Musharraka capital at its historical cost at which it was initially recognized. However, in case of
a Diminishing Musharraka, the value of investment should be reduced if there is any repayment
of Musharka capital by the client.

Illustration 1.5
On March 3, 20XX, ABC Islamic bank advanced $300,000 to a client under a Musharraka arrangement
for establishing a business. The duration of Musharrka contract is three years. The total capital invested
in the business is $1,000,000. Hence, initially, ABC Islamic bank own 30% of the equity of the
business.
At the end of the period, as stipulated in the contract, client payed back $100,000 of principal. Islamic
bank should reduce the amount of its Musharraka capital by $100,000. The accounting entry will be:

Date Description Dr. Cr.

Mar 3, 20X3 Cash $100,000
Musharraka Capital $100,000

2.2.3 Recognition of Musharraka Profit and Loss

Single Period Musharraka

Islamic bank should recognize the profit / (loss) resulting from a Musharraka investment in the
year in which it was earned.

For a single period Musharraka, a Musharraka that commences and ends during a single
accounting period), the profit or loss shall be recognized at the time of liquidation of the
Musharraka. The same treatment will be applied for the Constant and the Diminishing
Musharraka.
16 Chapter One Murabaha and Murabaha to the Purchase Orderer

Illustration 1.6
An Islamic bank signed a short term Musharraka contract with a client to import and sell a product.
The funds were transferred from the bank to the client on January 3, 20XX and the transaction cycle
completed on April 30, 20XX. The Musharraka investment made by the bank was $700,000 and the
net profit earned on the investment was $80,000. The profit sharing rations was 70:30 (bank:
customer).
The principle amount of the Musharraka and the bank’s share of the profit were transferred to the
bank on April 30, 20XX. The Islamic bank should recognize the profit of $56,000 ($80,000 x 70%)
on the liquidation of Musharraka on April 30, 20XX. The accounting entry will be:
Date Description Dr. Cr.
Apr 30, 20XX Cash $56,000
Musharraka Profit $56,000

The payment of principal amount should also be recorded into the books of the bank. The accounting
entry will be:
Date Description Dr. Cr.
Apr 30, 20XX Cash $700,000
Musharraka Capital $700,000
17 Chapter One Murabaha and Murabaha to the Purchase Orderer

Multi-Period Constant Musharraka

A multi-period Musharraka is a Musharraka that continues for more than one accounting period.
In case of multi-period constant Musharka financing, Islamic bank’s share of profit should
recognized when it is distributed.

Illustration1.8
Illustration1.7
ABC Islamic bank signedprovideda multi-period musharka
Musharka capital contract to
of $350,000 with a client
a client forfor importing
a Fintech and selling
startup. the
The funds
goodstransferred
were in the localfrom
market. The contract
the bank was on
to the client signed on January
January 1, 20XX
13, 20XX. At theand
endbank provided
of first financing
year operations,
of $3,000,000
the to thea loss
startup incurred client. During theThe
of $200,000. firstmanagement
year operations,
stronglythebelieve
Musharraka
that in earned a profit
the second year of
of
$400,000. The profit sharing ration of bank and client is 60% and 40% respectively.
operations, the startup will earn profits enough to recover this loss and generate a good return for the
bank. However, the management decided to adjust a loss of $50,000 to the musharka capital.
(i) The bank received its share of the profit from the client on December 28 th 20XX.
In this case, ABC Islamic bank should recognize a loss of $50,000. The accounting entry will be:
ABC Islamic bank should recognize the profit of $240,000 ($400,000 x 60%) when received by the
bank.
DateThe accounting entry will be:
Description Dr. Cr.
Dec 31, 20XX Loss incurred on Musharraka investment $50,000
Date Description Dr. Cr.
Musharraka Capital $50,000
Dec 28, 20XX Cash $240,000
Profit earned on Musharraka investment $240,000

(ii) In the above example, the management of the musharka came to know an opportunity to re-
invest the profits in the business. After securing the consent of the bank, the management re-
invested the whole profit of $400,000 to enhance the production capacity of the business.
In this case, ABC Islamic Bank should not recognize a profit in the current period. (Check from the
standard).

In case of loss, Islamic bank should recognize the loss to the extent the management of
Musharraka adjust it to the musharraka Capital.
18 Chapter One Murabaha and Murabaha to the Purchase Orderer

Multi-period Diminishing Musharka

In case of a Diminishing Musharraka, the Musharraka capital decline over the life of the
Musharraka. So for a Diminishing Mushaarraka, the Islamic bank will recognize its share of the
profit and will also recognized the decline in the Musharraka capital at the end of each year.

Illustration1.9
On January 03, 20XX, ABC Islamic bank signed a diminishing Musharraka contract with a client for
construction of a housing unit. Bank had to provide $200,000 and the client would invest $300,000.
The funds were transferred to the customer on January 05, 20XX. Both parties agreed to share profit
and loss in proportion of their capital ratios. The profit calculation will be based on the capital shares
of each partner at the start of the year.
The rent agreed in the contract is $100,000 per annum. It is further agreed that client will purchase
equity share of bank worth $100,000 each year.
At the end of first year, ABC Islamic bank will recognize its share of rental profit.
ABC Islamic Bank’s profit = capital ratio x total rent = 0.4 x $100,000 = $40,000
Bank will recognize a Musharraka income of $40,000. The accounting entry will be:
Date Description Dr. Cr.
Dec 31, 20XX Cash $40,000
Profit earned on Musharraka investment $40,000

In case of a Diminishing Musharraka, the bank will also recognize the decrease in the Musharraka
capital. Hence, ABC bank will also recognize the proceeds of $100,000 against sale of 20% of the
equity capital. The accounting entry will be:

Date Description Dr. Cr.

Dec 31, 20XX Cash $100,000
Musharraka Capital $100,000

2.2.5 Accounting on liquidation

On liquidation of Musharraka, Islamic bank will recover its capital invested in the Musharraka.
The profit / loss, which are not due to the misconduct or negligence of mudarib, should be
recognized at the time of liquidation.
19 Chapter One Murabaha and Murabaha to the Purchase Orderer

Illustration 1.10
ABC Islamic bank had made a five long Musharraka investment on January 12, 20XX. The total
Musharraka investment capital provided by the bank was of $100,000. On liquidation, only $80,000
could be recovered. The loss was due to the normal business factors.
ABC Islamic bank should recognize a loss of $20,000 on liquidation that will be charged to the profit
and loss account. The accounting entry will be:
Date Description Dr. Cr.
Dec 31, 20XX Cash $80,000
Loss incurred on Musharraka investment $20,000
Musharraka Capital $100,000

It was discussed in detail that a partner in Musharraka is not required to guarantee the capital
investment of the other partner. Each partner takes capital risk to earn profit in a Musharraka
venture. However, a partner can be asked to provide guarantee for his/her explicit misconduct
and negligence. Hence, if a mudarib fails to pay the cash on liquidation or losses are due to
misconduct or his/her negligence, Islamic bank should record a receivable from the mudarib.

Illustration 1.11
In the above example, during the liquidation process, it was revealed that the mudarib undersell the
assets to his friends. Had the mudarib not under-priced the assets, bank would not have to bear any
loss.
The Islamic bank should recognize a receivable of $20,000 on liquidation from mudarib. The
accounting entry will be:
Date Description Dr. Cr.
Dec 31, 20XX Cash $80,000
Receivable from mudarib $20,000
Musharraka Capital $100,000
20 Chapter One Murabaha and Murabaha to the Purchase Orderer

Concept Check
Identify which of the following five statements are true or false. If a statement is false, indicate why
this statement is false:
1) In case of a constant Musharraka, Islamic bank should continue to recognize the Musharraka capital
at its cash equivalent price.
2) For single period Musharrakas, different accounting treatments are used to recognize profit for the
constant and diminishing Musharrakas.
3) In case of multi-period constant Musharka financing, Islamic bank’s share of profit should
recognized when it is distributed.
4) For a Diminishing Mushaarraka, the Islamic bank will recognize the decline in the Musharraka
capital at the end of each year and all the profit/loss will recognized at the time of liquidation of
Musharraka.
5) On liquidation of Musharraka, Islamic bank will recover its capital invested in the Musharraka. The
profit / loss, which are not due to the misconduct or negligence of mudarib, should be recognized at the
time of liquidation.

Solution:
1. False.
In case of a constant Musharraka, Islamic bank should continue to recognize the Musharraka
capital at its historical cost at which it was initially recognized.
2. Falae.
For single period Musharrakas, different accounting treatments are used to recognize profit
for the Constant and Diminishing Musharrakas . For a single period Musharraka, a
Musharraka that commences and ends during a single accounting period), the profit or loss
shall be recognized at the time of liquidation of the Musharraka.
3. True.
4. False.
In case of Diminishing Musharraka, at the end of each accounting period, the Islamic bank
will recognize its share of the profit and will also recognized the decline in the Musharraka
capital at the end of each year.
5. True.

Session Summary:
 Subsequent to their initial recognition the Constant Musharrka and the Diminishing
Musharraka are measured differently. In case of a Constant Musharraka, Islamic bank
should continue to recognize the Musharraka capital at its historical cost at which it was
initially recognized. However, in case of a Diminishing Musharraka, the value of investment
should be reduced if there is any repayment of Musharka capital by the client.
 Islamic bank should recognize the profit / (loss) resulting from a Musharraka investment in
the year in which it was earned. For a single period Musharraka, the profit or loss shall be
recognized at the time of liquidation of the Musharraka. The same treatment will be applied
for the Constant Musharraka and the Diminishing Musharraka.
 In case of multi-period constant Musharraka financing, Islamic bank’s share of profit should
recognized when it is distributed. In case of loss, Islamic bank should recognize the loss to
21 Chapter One Murabaha and Murabaha to the Purchase Orderer

the extent the management of Musharraka adjust it to the Musharraka Capital.

 In case of a Diminishing Musharraka, the Musharraka capital decline over the life of the
Musharraka. So for a Diminishing Mushaarraka, the Islamic bank will recognize its share of
the profit and will also recognized the decline in the Musharraka capital at the end of each
year.
 On liquidation of Musharraka, Islamic bank will recover its capital invested in the
Musharraka. The profit / loss, which are not due to the misconduct or negligence of mudarib,
should be recognized at the time of liquidation. However, if a mudarib fails to pay the cash
on liquidation or losses are due to misconduct or his/her negligence, Islamic bank should
record a receivable from the mudarib.

2.3 IFRS Perspective

Under IFRS, Musharraka is considered a join arrangement between a bank and its customer.
IFRS 11 defines a joint arrangement as an arrangement of which two or more parties have joint
control and the following characteristics are present:
1): The parties are bound by a contractual arrangement.
2): The contractual arrangement gives two or more of the parties joint control of the
arrangement.
To have joint control means that all the parties, or a group of the parties, share control (defined in
IFRS 10) of the arrangement collectively and decisions about the relevant activities that
significantly affect the returns of the arrangement require the unanimous consent of all parties, or
group of the parties, that collectively control the arrangement (IFRS 11).
A joint arrangement can be further classified as a joint operation or a joint venture. A joint
operation is a joint arrangement whereby the parties that have joint control of the arrangement
have rights to the assets, and obligations for the liabilities, relating to the arrangement (IFRS 11,
para 15). A joint venture, on the other hand, is a joint arrangement whereby the parties that have
joint control of the arrangement have rights to the net assets of the arrangement (IFRS 11, para
16).
So, for every Musharraka an Islamic bank has to decide if it is a joint arrangement. Firstly, the
Islamic bank should assess whether or not all parties or a group of parties to control the
arrangement. Secondly, the Islamic bank should assess whether it has joint control of the
arrangement. Joint control exists when decisions about the relevant activities require the
unanimous consent of the parties that collectively control the arrangement (Alamad 2019).
Once it has been determined that the Musharraka is joint arrangement. Then it should be
classified as either a joint operation or a joint venture. The Islamic bank should consider:
(a) the structure of the joint arrangement;
(b) the legal form of any separate vehicle
22 Chapter One Murabaha and Murabaha to the Purchase Orderer

(c) the terms of the contractual arrangement with a separate vehicle

(d) when relevant, other facts and circumstances
(IFRS11, Appendix B, para 5, 6, and 15)

2.3.1 Musharka Identified as Joint Operation

If it is determined that the joint arrangement between the client and the bank is a joint operation,
then the bank shall recognize in relation to its interest in a joint operation:
(a) its assets, including its share of any assets held jointly;
(b) its liabilities, including its share of any liabilities incurred jointly;
(c) its revenue from the sale of its share of the output arising from the joint operation;
(d) its share of the revenue from the sale of the output by the joint operation; and
(e) its expenses, including its share of any expenses incurred jointly.
(IFRS 11, para 20)

Measurement of the Musharraka Capital

Islamic bank should measure the Musharraka capital paid in cash or made available to the
customer on account at the face value of cash paid. However, if all or part of the fund in kind,
e.g. trading assets or non-montary assets for use in the venture, such assets should usually be
measured at their fair value (IFRS 11, Appendix B, para 33A).

Illustration 1.12
ABC Islamic provided $100,000 in cash and a commercial apartment as Musharraka capital
for investment in real estate project. At the time of the transfer, the fair price of the apartment
was $300,000. The funds and the apartment were effectively transfer to the client on
February 3, 20XX.
The Islamic bank should recognize the Musharraka capital at a value equal to the cash funds
transferred to the Musharraka and the fair value of the apartment. The accounting entry will
be:
Date Description Dr. Cr.
Feb 3, 20XX Musharraka Capital $400,000
Cash Account $100,000
Office Apartment $300,000

Both of the parties may incur some expenses in the pre-Musharraka period that are related to the
Musharraka. These expenses should not be included in the Musharraka capital rather should be
charged to profit and loss account of the respective entity (IFRS 11, Appendix B, para 33A).
23 Chapter One Murabaha and Murabaha to the Purchase Orderer

Illustration 1.13
ABC Islamic hired a consultant to conduct a feasibility study of a commercial plaza to
evaluate the profitability of the project proposed by a client. It paid $40,000 to the consultant.
Bank provided $760,000 under the Musharka financing contract on January, 03 20XX. The
Islamic bank should recognize the Musharraka capital in amount equal to the total of funds
delivered to the client. The accounting entry will be:
Date Description Dr. Cr.
Feb 3, 20XX Musharraka Capital $760,000
Cash Account $760,000

The cash paid to the consultant will be recognized as expense in the current period. The
accounting entry will be:
Date Description Dr. Cr.
Feb 3, 20XX Consultancy expense $40,000
Cash Account $40,000

Subsequent Measurement of the Musharraka Capital

Under IFRS, the constant Musharraka and the diminishing Musharraka will be accounted for
differently after their initial recognition. The constant Musharraka will continued to be measured
at its historical cost at which it was initially recognized. However, if there is a significant
decrease in the price of the Musharraka assets, then the Islamic bank shall recognized its share of
the impairment loss (IFRS 11, Appendix B, para 33A).

Illustration 1.12
ABC Islamic provided $200,000 in cash and a commercial property as Musharraka capital for
investment in real estate project. At the time of the transfer, the fair price of the commercial
property was $300,000. The funds and the apartment were effectively transfer to the client on
February 3, 20XX. Musharraka capital was initially recognized at $500,000. The client also
invested $500,000 in the venture. The starting capital ratio was 50:50.
On December 02, 20XX, because of a fire related accident, the commercial property was
significantly damaged. The fair price of the commercial property has been decreased to
$200,000. The total impairment loss will $100,000 and the bank will recognize the 50% of
this impairment loss.
Date Description Dr. Cr.
Feb 3, 20XX Impairment Loss $50,000
Musharraka Capital $50,000

In case of the Diminishing Musharraka, a portion of bank’s share in Musharraka capital is

transferred from the bank to the client at the end of each accounting period. Such a transfer of the
Musharraka capital can take place at either at the historical cost of the Musharraka capital or at a
price agreed between the client and the bank. If the transfer take place at a price which is
24 Chapter One Murabaha and Murabaha to the Purchase Orderer

different from the historical price of the Musharraka capital, then the Islamic bank will recognize
a gain or loss on the sale.
Illustration 1.5
On March 3, 20XX, ABC Islamic bank advanced $300,000 to a client under a Musharraka arrangement
for establishing a business. The duration of Musharrka contract for the bank is three years. The total
capital invested in the business is $1,000,000. Hence, initially, ABC Islamic bank own 30% of the
equity of the business. At the end of each year, 10% equity of the business will be transferred from the
bank to the client. It was decided the transfer will take place at a 20% premium over the historical cost
of the Musharraka.

At the end of the first year, as stipulated in the contract, client payed back $120,000 of principal.
Islamic bank should reduce the amount of its Musharraka capital by $100,000 and will recognize a gain
of $20,000. The accounting entry will be:

Date Description Dr. Cr.

Dec 31, 20XX Cash $120,000
Musharraka Capital $100,000
Gain on sale of Musharraka Capital $20,000

Recognition of Profit and Loss

At the end of the each accounting period, the Islamic bank will recognize its share of the total
revenue of the Musharraka and the Islamic bank will also recognize its share of total expense of
the Musharraka.
In case of the single period Musharraka, the total revenue and total expenses will be recognized
at the end of the accounting period.
25 Chapter One Murabaha and Murabaha to the Purchase Orderer

Illustration 1.6
An Islamic bank signed a short term Musharraka contract with a client to import and sell a product.
The funds were transferred from the bank to the client on January 3, 20XX and the transaction cycle
completed on April 30, 20XX. The Musharraka investment made by the bank was $700,000. Over the
period of Musharraka, the business earned total revenue of $150,000 and total expenses of $70,000.
The profit sharing rations was 70:30 (bank: customer).
Islamic bank’s share of total revenue = $150,000 x 70% = $105,000
Islamic bank’s share of total expenses = $70,000 x 70% = $49,000
The principle amount of the Musharraka and the bank’s share of the profit were transferred to the
bank on April 30, 20XX. The Islamic bank should recognize its share of the revenue and its share of
expenses on the liquidation of Musharraka on April 30, 20XX. The accounting entry will be:
Date Description Dr. Cr.
Apr 30, 20XX Cash $56,000
Musharraka expenses $49,000
Musharraka Revenue $105,000

The payment of principal amount should also be recorded into the books of the bank. The accounting
entry will be:
Date Description Dr. Cr.
Apr 30, 20XX Cash $700,000
Musharraka Capital $700,000

In case of the Multi-period Musharraka, at the end of each accounting period, the Islamic bank
will recognize its share of the profit/loss.
26 Chapter One Murabaha and Murabaha to the Purchase Orderer

Illustration1.9
On January 03, 20XX, ABC Islamic bank signed a diminishing Musharraka contract with a client for
construction of a housing unit. Bank had to provide $200,000 and the client would invest $300,000.
The funds were transferred to the customer on January 05, 20XX. Both parties agreed to share profit
and loss in proportion of their capital ratios. The profit calculation will be based on the capital shares
of each partner at the start of the year.
The rent agreed in the contract is $100,000 per annum. It is further agreed that client will purchase
equity share of bank worth $100,000 each year. During the first year, for repairs, the expenses of
$10,000 was incur.
At the end of first year, ABC Islamic bank will recognize its share of rental profit.
ABC Islamic Bank’s share of rent = capital ratio x total rent = 0.4 x $100,000 = $40,000
ABC Islamic Bank’s share of expenses = capital ratio x total expenses = 0.4 x $10,000 = $4,000
Bank will recognize a Musharraka revenue of $40,000 and an expense of $4,000. The accounting
entry will be:
Date Description Dr. Cr.
Dec 31, 20XX Cash $36,000
Musharraka Expense $4,000
Musharraka Revenue $40,000

In case of a Diminishing Musharraka, the bank will also recognize the decrease in the Musharraka
capital. Hence, ABC bank will also recognize the proceeds of $100,000 against sale of 20% of the
equity capital. The accounting entry will be:

Date Description Dr. Cr.

Dec 31, 20XX Cash $100,000
Musharraka Capital $100,000

Liquidation of Musharraka
At the end of the Musharraka contract, the Islamic bank will recover the capital it has invested in
the Musharraka. The Islamic bank will recognize loss/profit on the Musharraka capital, which is
not due to the gross negligence of the partners in the business. This treatment is similar to the
treatment suggested by FAS 4.
27 Chapter One Murabaha and Murabaha to the Purchase Orderer

Illustration 1.10
ABC Islamic bank entered into a three years long Musharraka contract with one of its customers on
January 1, 20XX. The total Musharraka investment capital provided by the bank was of $200,000. On
liquidation, only $170,000 could be recovered. The loss was due to the normal business factors and
could not have not been assigned to negligence of any of the partners.
ABC Islamic bank should recognize a loss of $30,000 on liquidation that will be charged to the profit
and loss account. The accounting entry will be:
Date Description Dr. Cr.
Dec 31, 20XX Cash $170,000
Loss incurred on Musharraka investment $30,000
Musharraka Capital $200,000

In the case, where loss is due to the negligence of one of the partners, then the Islamic bank
should recognize an account receivable.

Illustration 1.10
ABC Islamic bank entered into a three years long Musharraka contract with one of its customers on
January 1, 20XX. The total Musharraka investment capital provided by the bank was of $200,000. On
liquidation, only $170,000 could be recovered. It was agreed between the client and the bank that the
loss was created because of the demonstrated negligence of the client.
ABC Islamic bank should recognize a loss of $30,000 on liquidation that will be charged to the profit
and loss account. The accounting entry will be:
Date Description Dr. Cr.
Dec 31, 20XX Cash $170,000
Musharraka Account Receivable $30,000
Musharraka Capital $200,000
28 Chapter One Murabaha and Murabaha to the Purchase Orderer

Concept Check
Identify which of the following five statements are true or false. If a statement is false, indicate why
this statement is false:
1) Under IFRS, the Islamic bank will recognize the Musharraka initially at the fair value of the funds
and assets in kinds invested in the Musharraka.
2) Expenses that incurred in the process of forming a Musharraka contract should be added to the
Musharraka capital by the Islamic bank.
3) In case of multi-period Musharka financing, Islamic bank’s will recognize its share of the revenue
and expenses at the end of each accounting period.
4) For a Diminishing Mushaarraka, the Islamic bank will recognize the decline in the Musharraka
capital at the end of each year and all the profit/loss will recognized at the time of liquidation of
Musharraka.
5) On liquidation of Musharraka, Islamic bank will recover its capital invested in the Musharraka. The
profit / loss, which are not due to the misconduct or negligence of mudarib, should be recognized at the
time of liquidation.

Solution:
1. True.
2. False.
Both of the parties may incur some expenses in the pre-Musharraka period that
are related to the Musharraka. These expenses should not be included in the
Musharraka capital rather should be charged to profit and loss account of the
respective entity.
3. True.
4. False.
In case of Diminishing Musharraka, at the end of each accounting period, the Islamic
bank will recognize its share of the profit and will also recognized the decline in the
Musharraka capital at the end of each year.
5. True.

Session Summary:
 Under IFRS, Musharraka is considered a join arrangement between a bank and its customer.
IFRS 11 defines a joint arrangement as an arrangement of which two or more parties have
joint control, the parties are bound by a contractual arrangement, and the contractual
arrangement gives two or more of the parties joint control of the arrangement.
 A joint arrangement can be further classified as a joint operation or a joint venture. A joint
operation is a joint arrangement whereby the parties that have joint control of the
arrangement have rights to the assets, and obligations for the liabilities, relating to the
arrangement. The accounting treatment for the joint operation is described in IFRS 11.
 A joint venture is a joint arrangement whereby the parties that have joint control of the
arrangement have rights to the net assets of the arrangement. Joint ventures are accounted
for using the equity method.
29 Chapter One Murabaha and Murabaha to the Purchase Orderer

 According to IFRS 11, Islamic bank should measure the Musharraka capital paid in cash or
made available to the customer on account at the face value of cash paid. However, if all or
part of the fund in kind, e.g. trading assets or non-montary assets for use in the venture, such
assets should usually be measured at their fair value.
 Under IFRS, the constant Musharraka will continued to be measured at its historical cost at
which it was initially recognized. In case of the Diminishing Musharraka, the transfer of the
Musharraka capital take place at either at the historical cost of the Musharraka capital or at a
price agreed between the client and the bank. If the transfer take place at a price which is
different from the historical price of the Musharraka capital, then the Islamic bank will
recognize a gain or loss on the sale of the capital.
 At the end of the each accounting period, the Islamic bank will recognize its share of the
total revenue of the Musharraka and the Islamic bank will also recognize its share of total
expense of the Musharraka.
 At the end of the Musharraka contract, the Islamic bank will recover the capital it has
invested in the Musharraka. The Islamic bank will recognize loss/profit on the Musharraka
capital, which is not due to the gross negligence of the partners in the business. In the case,
where loss is due to the negligence of one of the partners, then the Islamic bank should
recognize an account receivable.

Chapter Summary
 A Muharraka is a contractual partnership between two or more parties whereby each partner
contributes a specific amount of money in a manner that gives each one a right to deal in the
assets of the partnership, on condition that the profit is distributed according to the partnership
30 Chapter One Murabaha and Murabaha to the Purchase Orderer

agreement and that the losses are borne in accordance with the contribution of each partner to the
capital.
 There are two types of Musharraka: Diminishing Musharraka and Constant Musharraka.
 In a Constant Musharaka, the partners’ shares in the capital remain constant throughout the
period of partnership, as specified in the contract. In a Diminishing Musharaka, the Islamic bank
agrees to transfer gradually to the other partner its share in the Musharaka, 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.
 A Musharraka requires that each partner should have all the qualities that are required to be an
agent. In Musharaka, the capital must be contributed by all partners. Capital can be in the form of
monetary assets or in the form of tangible assets.
 The proportion of profit to be distributed between or among partners must be agreed upon at the
time of effecting the contract. Partners can agree to any profit sharing mechanism and ratios of
their own choosing. However, the proportions of losses borne by partners must be equal to the
proportions of their capital contributions.
 Presented below is the accounting flow of transactions in a Musharrka contract and their
respective entries:

Sr # Event Dr. Cr.

1 Initial Recognition of Musharrka Musharraka Capital Cash / Tangible Assets
2 Year-end Measurement Cash Musharraka Capital
Diminishing Musharraka
3 Profit recognition and liquidation Cash Musharraka Capital
of a single year Musharaka Musharraka Profit
4 Profit/loss recognition Multi-period Cash Profit on Muharraka
Musharaka investment.
Loss on Musharraka Musharraka Capital
Investment
5 Liquidation of Musharraka Cash
31 Chapter One Murabaha and Murabaha to the Purchase Orderer

Definitions
Musharrka: A Muharraka is a contractual partnership between two or more parties whereby
each partner contributes a specific amount of money in a manner that gives each one a right to
deal in the assets of the partnership, on condition that the profit is distributed according to the
partnership agreement and that the losses are borne in accordance with the contribution of each
partner to the capital
Constant Musharraka: In Musharaka where the partners’ shares in the capital remain constant
throughout the period of partnership, as specified in the contract.
Diminishing Musharrka: A Musharaka where the Islamic bank agrees to transfer gradually to
the other partner its share in the Musharaka, 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.
Mudarib: A participant in a Musharraka contract.
Historical cost of Musharrka: The sum of the capital, in cash or in kind, invested by a partner
in a Musharrka at the time inception of the Musharraka.
Cash equivalent value: The number of monetary units that would be realized if an asset was
sold for cash in the normal course of business as of the current date (Concept Statement, para
89).
Face value: The amount of a Murabaha receivable based on the price agreed between the clients
and the Islamic bank including the latter’s profit on the transaction.
32 Chapter One Murabaha and Murabaha to the Purchase Orderer

Review Questions
Multiple Choice Questions
1. On March 23, 20XX, ABC Islamic Bank transferred cash of $300,000 and an apartment
to a client. The bank had acquired the apartment for $200,000 and the current book
value of the apartment is equal to $150,000. Partners in Musharraka agreed that the
apartment was worth $300,000. What is the total contribution of the ABC Islamic Bank
in the Musharraka?
a) $500,000
b) $350,000
c) $450,000
d) $600,000
2. On March 23, 20XX, ABC Islamic Bank transferred cash of $300,000 and an apartment
to a client. The bank had acquired the apartment for $200,000 and the current book
value of the apartment is equal to $150,000. Partners in Musharraka agreed that the
apartment was worth $300,000. What would ABC recognize as gain/loss?
a) $150,000
b) $200,000
c) $100,000
d) $300,000
3. On January 03, 20XX, ABC Islamic bank signed a diminishing Musharraka contract with
a client for construction of a housing unit. Bank had to provide $200,000 and the client
would invest $300,000. Both parties agreed to share profit and loss in proportion of their
capital ratios at the start of the year. The rent agreed in the contract is $100,000 per
annum. At the end of each period, $50,000 of Musharraka will be transferred from the
bank to the client. What will be the share of profit of the bank at the end of the second
year?
a) $40,000
b) $50,000
c) $30,000
d) $25,000
4. ABC Islamic bank had made a five long Musharraka investment on January 12, 20XX.
The total Musharraka investment capital provided by the bank was of $100,000. On
liquidation, only $80,000 could be recovered. The loss was due to the normal business
factors. How will the bank recognize the transaction at the time of liquidation of
Musharraka contract?
a) Debit: Cash = $100,000,
Credit: Musharraka Capital = $100,000
b) Debit: Cash = $80,000, Musharraka loss = $20,000
Credit: Musharraka Capital = $100,000
c) Debit: Cash = $100,000, Musharraka Receivable = $20,000
33 Chapter One Murabaha and Murabaha to the Purchase Orderer

Credit: Musharraka Capital = $100,000

d) Debit: Cash = $80,000,
Credit: Musharraka Capital = $80,000
5. On February 3, 20XX, ABC Islamic provided $100,000 in cash and a commercial
apartment as Musharraka capital for investment in real estate project. At the time of the
transfer, the fair price of the apartment was $300,000 and the book value of the
apartment is $200,000. Under IFRS, how will the Islamic bank recognize the transaction
February 3, 20XX?
a) Debit: Musharraka Capital = $300,000,
Credit: Cash = $100,000, Office Apartment = $200,000
b) Debit: Musharraka Capital = $400,000,
Credit: Cash = $100,000, Office Apartment = $300,000
c) Debit: Musharraka Capital = $300,000,
Credit: Office Apartment = $300,000
d) Debit: Musharraka Capital = $100,000,
Credit: Cash = $100,000

True/False
1. For a multi-period diminishing Musharraka, the transfer of capital from the bank to
the client is recognized at the end of each accounting period.
True/False

2. On March 02, 20XX, ABC Islamic bank signed a diminishing Musharraka contract
with a client for construction of a commercial property. Bank had to provide $500,000
and the client would invest $1,000,000. Both parties agreed to share profit in 1:4. The
rent agreed in the contract is $300,000 per annum. The bank’s share of the profit of the
first year will $60,000..
True/False

3. ABC Islamic bank had made a five long Musharraka investment on January 20, 20XX.
The total Musharraka investment capital provided by the bank was of $120,000. On
liquidation, only $70,000 could be recovered. The loss was due to the negligence of the
client. ABC Islamic bank will recognize a loss of $50,000.
True/False

4. In a Musharraka, all the partners have to contribute capital and have to participate in
management of the firm
True/False

5. A person who temporary lacks the abilities to act as agent, but can meet requirement
later, can sign a Musharrak contract. r.
True/False
34 Chapter One Murabaha and Murabaha to the Purchase Orderer

Short Case
On February 2, 20XX, Hammad, CFO of XYZ Group of Companies, presented a plan of
establishing a shipping company. XYZ Group of Companies is a major conglomerate based in
Dubai and owns companies that operate in many different industries, i.e., textiles, fertilizers,
retail, petroleum, and sugar. The group has gone through a period of exponential growth over
the last five years, and this growth is expected to continue in the near future. Manufacturing
operations of the XYZ Groups of Companies are based in South Asia, and their output is
exported to customers in South East Asian and far eastern countries. Establishing a shipping
company will decrease the cost of transporting the product by at least 20%. Much of the growth
in the recent past had been backed by debt financing that had increased the group's credit risk
significantly. The debt financing was available for the current project as well; however, the cost
of debt had risen considerably for the group. The board of directors showed a preference for
financing this new venture by forming a partnership with a financing institution.
After getting approval from the board of directors, Hammad presented the plan for a possible
partnership to ABC Islamic Bank. After extensive negotiation, ABC Islamic bank has decided to
form a Diminishing Musharrka contract with the XYZ Group of Companies. Each of the two
partners would provide 50% of the financing required for establishing the new venture. The
shipping company would be based in Chittagong port and would start by buying five shipping
vessels. The XYZ Group of Companies would be responsible for managing the venture. It was
agreed between the ABC Islamic Bank and the XYZ Group of Companies that the bank would get
80% in proportion to its share of capital at the start of the year of the total profit generated by
the venture, and the rest of the profit would belong to the XYZ Group of Companies. However,
the loss would be shared between the partners according to their share in the capital of the
venture. At the end of each year, 10% of the total capital invested by the bank in the venture
would be transferred to the XYZ Group of Companies. The transfer would take place at the
historical cost of the Musharraka Capital.
On March 21, 20XX, ABC Islamic Bank and the XYZ Group Companies mutually decided that
the XYZ Group Companies would act as the principal-agent in buying the venture's assets. The
total capital required for establishing the venture was estimated to be $10,000,000. ABC Islamic
Bank transfered its share of Musharraka Capital, i.e. $5,000,000, to the XYZ Group of
Companies on April 14, 20XX. The shipping company started its operations in May 20XX. At the
end of the first years of operations, the shipping company had produced a total profit of
$1,200,000. The total revenue for the year was $2,300,000, and the total expenses for the year
were $1,100,000. At the end of the second year of operations, the shipping company had
produced a total loss of $500,000 over the year. The total revenue for the year was $1,700,000,
and the total expenses for the year were $2,200,000. ABC Islamic Bank will adjust only 50% of
its share of loss towards the Musharraka capital At the end of each year, a part of bank's share
of capital was transferred to the XYZ Group of Companies as agreed in the contract.

You are required to:

a): Provide a table that will show the transfer of equity from the bank to the client and a table
that shows the assigned shares of profit of the bank and the
b): Provide appropriate accounting entries for the initial recognition of Musharraka Contract.
c): Provide appropriate accounting entries for the recognition of profit at the end of first year.
35 Chapter One Murabaha and Murabaha to the Purchase Orderer

d): Provide appropriate accounting entries for the transfer of Musharraka capital to the bank to
the client at the end of the first year.
e): Provide appropriate accounting entries for the recognition of loss at the end of first year.
f): Provide appropriate accounting entries for the transfer of Musharraka capital to the bank to
the client at the end of the second year.
g): Please repeat b, c, d, e, and f, if the bank follows IFRS accounting standards.