Financial Reporting Issues relating to

Islamic Finance

I strongly think customers would be unfairly treated by the IFIs under 'effective profit rate method'.  Often, customers are not even aware that their repayment to the IFIs are calculated based on this method.  Therefore, in the event of an early settlement by a customer, he will have a surprise of his life when finding the total settlement amount to be much higher, even though the total repayments which have been made should result in a lower full settlement amount. No thanks to this innovative 'effective profit rate method' which is borrowed from conventional system.  This can be seen as a form of disincentive for customers whom opt for early settlements.  Whilst it is not intentionally designed by IFIs to explicitly punish customers, the motive is quite apparent which is to protect IFIs's interest and to transfer risk rather than risk sharing.

In my opinion, EPRM or SLM method is not an issue if customer continue to serve the financing until the end of tenure because the repayment amount is the same for both. It is only become an issue of unfairness to customer if the customer want to do early settlement of which the principal outstanding is still higher using EPRM as compared to SLM. However, we also need to look on the banking’s point of view. When the customer sign the contract, it is considered a ‘promise’ to the bank that they will repay whatever they owe in a certain period of time. The fund that the bank has given to the customer has a cost attach to it. If customer broke the ‘promise’ by settling the financing earlier than promised period, bank would suffer opportunity loss. The fund which has been allocated to the borrower might be invested somewhere else which is more profitable. Moreover, the Bank might have included the profit to be earned from the financing in their cash flow projection in running daily operation or for any investment or financing activities. Early settlement would disrupt their banking activities. Thus, by looking at this view, it is fair for the bank to take higher profit at earlier repayment period to compensate for the possible loss of early settlement. My suggestion is (if system can accommodate for this), first, bank need to explain to customer on the EPRM/SLM method. If customer do not perform early settlement, Bank should be allowed to use EPRM method. However, if customer make an early settlement, Bank should calculate income based on SLM method. Any overstated income, understated principal should be adjusted accordingly. In addition, customer should be charged penalty as well because of early settlement. So, I think it will be fair to both side.

First of all, the re-branding of Effective Interest Rate Method into Effective Profit Rate is merely a trick that used to fool the innocents borrowers who neither care about the too sophisticated financial instruments given to them, nor they really understand that Islamic Financial Transaction should always be confined to the   Shariah Principles. In reality the profit rate used is the same interest rate used to determine the cost of borrowing in the conventional market. What distinguish an Islamic Banks from the conventional bank in substance when both banks are offering ribawi product ?

It is  worth to be reminded , conventional bank and Islamic bank operate based on different foundation and principle.In my opinion, profit maximization should not be the primary objective of Islamic Bank in running its business , since Islamic Moral Economy advocate social development that ensure fair and justice treatment to all level of community. EPRM is a method that bias against the banks , by which the bank claims higher profit during the early tenure of the financing contract and resulted in limited option for fund user in choosing their comfortable payment tenure. Obviously, it provokes higher risk upon the fund user. Therefore, from the standpoint of Shariah principle , EPRM is not the suitable method for IFIs even though it is convenient to copy and paste from their counterpart.  

Very interesting response, Limei Tew. However, we need to think further on the philosophy and model for Islamic Bank. What? How? Why? Who? When? Etc etc etc

Sis Zuraini, first, if we hv different method for those who would like to make prepayment, is it a fair approach for the others? Second, the bank image. Will their image tarnish from inconsistent policy? Indeed, there are 2 cases in the UK where the customer sued their banks and the judges decided that the bank should returned the so-called 'penalty' for early settlement. What we can learn from these cases?

Practices of using interest rate on loans is justified due to the fact that there is the greater benefit of receiving money now rather than later. Therefore, interest is considered as a direct measure for the time value of money (TVM).

I suppose that in conventional financing, the future cash flows, in particular, principles are not discounted correctly by means of effective interest rate method (EIRM). According to TVM principle, banks are supposed to get back their money (principle) as soon as possible and compensate lender through interest for deferred payments. More importantly, in my opinion, for early settlement banks should not charge interest at all and, the costs that lender will incur as a result of early settlement, should be covered by a client at the beginning while contracting a loan.

However, Islamic financing represents buy-sale transaction or a rent to sale transaction. There is always an underlying asset behind the deal. That’s why, they are able to use profit rate instead of utilizing the principle of TVM or interest. As a result, it is up to Islamic banks which one (principle or profit) they want to get back first and client have to pay the agreed amount of profit regardless of early settlement. Nevertheless, Islamic banks voluntarily give a rebate for earlier payments.

From the IFI point of view, profit maximization is still one of the ultimate goals while upholding the Islamic laws. In my opinion, due to that main reason and  to be competitive, IFI will use EPRM to their customers.

Yes, i believe the customers will be unfairly treated IF the EPRM method are not properly explained to the customers. IFI's officers must explain to the customers about the implication of the EPRM methods (how does it work) especially in the case of early settlement and if there is any rebate given to the customers, it also should be highlighted. Consequently, the customers enter into the contract without any gharar (they fully understand the contract) and do not feel like being cheated or oppressed.   

Interesting discussion Prof. I am following.

Generally, we know that there is no specific formula to calculate revenue for the Islamic Finance industry. Islamic Financial Institutions (IFIs) in Malaysia they practice Effective Profit Rate Method (EPRM) for revenue recognition which is method for collecting more profit from the beginning and less principal.

in my opinion according to this issue, though there is no standard which emphasizes that banks shouldn’t claim profit from the beginning, I consider EPRM unfair. Because, if we look the issues in EPRM, we can apprehend that bank is actually transferring risk to the customer by erasing the basic principle of Islamic Moral Economy (IME) which is risk-sharing.

 Hence, Islamic banks in Malaysia should formulate a good method for revenue recognition which is fair, instead of duplicating and practicing conventional finance model, because justice and fairness is part of the religion and in Islam, we should always stand for justice as a matter of principle, whether for Muslims or non-Muslims, even if justice should side against us.

Walaahu A3lam:

In Malaysia banks including IFIs are allowed to recognise revenue, or price their products based on the EPRM. Though this method is derived from the conventional financial system, it does not render Islamic financial contracts shariah non-compliant because it is only used for pricing purposes. Through such a method uniformity and a level playing field is achieved in the banking sector. It is envisaged that when the IF industry is able to formulate its own rate of recognising revenue, the EPRM would be replaced.

How ever the major concern is how installments arising from deferred payments are amortized. It is said that amortization is arranged in such a way that the principal (cost) part of the debt is separated from the profit, such that the early installments bear higher part of the profit than the principal (cost). I wish to state that, thisis a pure conventional form of amortization and must not be allowed under an Islamic banking system. Such a practice is equivalent to shifting risk to customers and does not entitle such banks to earn profit.

To comply with Shariah, Islamic banks should not segregate installment into cost and profit, but and installment should be seen as a single unit of part payment of debt.

Of course, Effective Profit Rate Method (EPRM) aka Effective Interest Rate Method is not a fair technique for the clients who would like to have an early settlement for a valid reason. We see, IFIs in contemporary days are spirited only by the profit motive discarding the Usul/Maqasid of the Shariah. That means many IFIs are not ready (or at least have no interest at all) to practice a fair and justified game alongside upbringing the ultimate societal development for all. Also, most of the current IFIs are tempted to mirror the unjustified and unethical conventional system or practices concerning their greedy nature thinking of only about themselves leaving the clients' interest behind but in Islamic Finance, which should not be the case.

The clients who would like to get the deposited/invested money back for a true/real reason earlier than the promised/agreed period, it's really a punishment for them as they need to pay more by the name of unsettled principle due to the EPRM. Moreover, most of the time, clients' were not aware of about this policy as IFIs does not disclose it verbally but put a note at the end with a tiny font which requires a magnifying glass (literally) to read on.

Therefore, I do believe, Straightline Profit Rate Method should be the ideal practice for the IFIs. However, considering IFIs' interest and a fair treatment, they may charge a penalty as low as 0.05% to 1.0% alongside a Straightline Profit Rate Method for the early settlers. One justification for this policy would be of BNM allow IFIs to charge a penalty of 1.0% for the clients who settle their part (of financing availed from IFIs) lately. Taking the same strategy, IFIs' point of view and a just treatment to the all, early settlement penalty should be limited within 0.05% to 1.0% of their deposits/investments.

As a customer of IFIs, I would expect the bank to share the risk with me, instead of shifting it. IFIs are expected to be more lenient when it comes to matters such as these ones that are of high ethics.

In another hand, if  we wear the banker's hat, we could see the matter differently. Quite often we blame the financial institutions and forget that their power is limited too. In Malaysia for example, a bank, as per the regulation can't use Straight Line Method even if it wanted to. Being in that situation, unless they want to close down their business they have to follow the guideline of the regulator who suggest the use of the Effective Profit Rate Method.

Having said that, I would suggest that we start by raising the concern to the regulator to allow or order the IFIs to use the SLM or come up with a better method that could count the principal and profit as one unit, which more in line with the shariah perspective.

I believe articles such as this one is playing the role of raising the awareness. Hence, academicians who are doing research in this line should attempt to get the message across the regulator and the IFIs for the betterment of the society and the application of the true Islamic Financing spirit through risk and profit sharing, instead of transferring it.

Some bankers claimed that EPRM is appropriate method in allocating profit to ifis because the financing given is a 'clean loan'.