31- Oct2020
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ISTISNA

INTRODUCTION

lstisna’ is a sale transaction where a commodity is transacted before it comes into existence. It is an order to a manufacturer to manufacture a specific commodity tor the purchaser. The manufacturer uses his own material to manufacture the required goods.

In Istisna’, the price must be fixed with the consent of all parties involved. All other necessary specifications of the commodity must also be fully settled.

Cancellation of contract

After giving prior notice, either party can cancel the contract before the manufacturing party has begun its work. Once be work starts, the contract cannot be canceled unilaterally.

Difference between Istisna’ and Salam:

The difference between lstisna‘ and Salamis as follows:

The subject matter must be an item that needs to be manufactured.

lstisna

The price does not necessarily need to be paid in full in advance. It is not necessary to pay the full price even at delivery either. It can be deferred to any time according to the agreement of the parties. The payment may also be made in installments.

The contract can be canceled before the manufacturer starts the work.

Salam

The subject maybe anything that may or may not need manufacturing.

The price has to be paid fully in advance

The contract cannot be canceled unilaterally.

Time of delivery

As pointed out earlier, it is not necessary for Istisna’ that the time of delivery is fixed. However, the purchaser may fix a maximum time tor delivery which means that if the manufacturer delays the delivery after the appointed time, he will not be bound to accept the goods or to pay the price.

In order to ensure that the goods are delivered within the specified period, some modern agreements of this nature contain a penalty clause to the effect that in case the manufacturer delays the delivery after the appointed time, he shall be liable to pay a penalty which shall be calculated on a daily basis. Can such a penal clause be inserted in a contract of lstisna’ according to Shariah? Although the classical jurists seem to be silent about this question while they discuss the contract of Istisna’, yet they have allowed a similar condition in the case of Ijarah. They say that if a person hires the services of a person to stitch his clothes, the fee may be variable according to the time of delivery. The hirer may say that he will pay Rs. 100/- in case the tailor stitches the clothes within one day and Rs. 80/- in case he prepares them after two days.

On the same analogy, the price in lstisna’ may be tied up with the time of delivery, and it will be permissible if it is agreed between the parties that in the case of delay in delivery, the price shall be reduced by a specified amount per day.

lstisna’ as a mode of financing

Istisna’ could be used as a mode of financing in the following manner:

Difference between Istisna’ and ljarah:

lstisna

The manufacturer uses his own material or obtains it to make the ordered goods.

The purchaser has a right to reject the goods after inspection as Shariah permits somebody who purchases a thing not seen by him, to cancel the sale after seeing it. The right of rejection only exists if the goods do not conform to the specifications agreed upon between the parties at the time of contract.

Ijarah tul Ashkhaas

The material is provided by the customer and the manufacturer uses only his labor and skill, i.e. his services are hired for a specified fee.

The right to reject goods after inspection does not exist.

  • Istisna ’ may be used to provide financing for house financing. If the client owns the land and seeks financing for the construction of a house, the financier may undertake to construct the house based on an istisna’. If the client does not own the land and wants to purchase that too, the financier can provide him with a constructed house on a specified piece of land. The financier does not have to construct the house himself. He can either enter into a parallel Istisna’ with a third party or hire the services of a contractor (other than the client). He must calculate his cost and fix the price of Istisna' with his client that allows him to make a reasonable profit over his cost.

  • The payment of installments by the client may start right from the day when the contract of Istisna’ is signed by the parties. In order to secure the payment of installments, the title deeds of the house or land, or any other property of the client may be kept by the financier as a security until the last installment is paid by the client. The financier will be responsible to strictly conform to the specifications in the agreement for the construction of the house. The cost of correcting any discrepancy would have to be borne by him.

  • Istisna’ can also be used for financing the working capital requirements of a manufacturer. The bank will order the manufacturer to manufacture certain specified goods and pays the Istisna’ price to the customer. Upon manufacturing the goods, the customer will deliver the goods to the bank. After taking possession of the goods, the buyer will sell the goods in the market at the same price and for this purpose, the bank may sell the goods directly or may appoint the same agent (including the customer) to sell their goods in the market.

  • lstisna’ may also be used for similar projects like installation of an air conditioner plant in the client’s factory, building a bridge or a highway, etc.

  • The modern BOT {Built, Operate and Transfer) agreements may be formalized through an Istisna’ agreement as well. So, if the government wants to build a highway, it may enter into an Istisna ’ contract with the builder. The price of Istisna’ maybe the right of the builder to operate the highway and collect toll taxes for a specific period.

Working capital financing using Istisna

Islamic Bank can also finance the working capital requirements of the company through the mode of Istisna’ in the following manner.

  • When a customer requires funds to fulfill his working capital requirements, the Islamic Bank will place an order with the customer to manufacture the finished goods of certain specifications.
  • After placing the order, the bank may make the payment of Istisna price at a lump sum or in installments.
  • After the finished goods are ready for delivery, the bank would receive the goods from the customer.
  • After receiving the goods the bank will sell the goods in the market, either directly or through some agent, to recover its cost price and earn some profit from the transaction.

Uses of Istisna’

  • House financing
  • Financing of plant / factory / building
  • Booking of apartments
  • BOT arrangements
  • Construction of buildings and plants

Accounting treatment of Istisna Transactions following points must be considered while developing Accounting treatment for Istisna transactions:

Following points must be considered while developing Accounting treatment for Istisna transactions:

  1. Profit Recognition
    If the bank has placed an “Order to Manufacture” to the customer to provide assets of certain specifications, then income will only be recognized by the bank once the bank has received the delivery’ of the goods and has also sold these goods in the market.
  2. Inventory
    The goods that are delivered by the customer, as per the bank’s order to Manufacture, will be recorded in the balance sheet of the bank as the inventory of the bank.

Example

A sample of accounting entries that can be used to record Istisna’transactions is as follows:

At the time of payment of Istisna price to the customer i.e. at the time of making an order to manufacture, the following entries would be passed:

January 01, 2011

  • Dr. Advance Against Istisna                  XXXXX
  • Cr Pay Order / Party Account               XXXXX

When the bank receives the possession of the goods, the following entries would be passed:

  • Dr. Inventory                                          XXXXX
  • Cr Advance against Istisna                   XXXXX

When the received goods are sold by the bank in the market, the following entries would be passed.

  • Dr. Istisna Financing                                                          XXXXX
  • Cr Inventory                                                                       XXXXX

At month-end, the following entries would be passed to record the income:

  • Dr. Istisna Profit Receivable                                              XXXXX
  • Cr Income on Istisna Financing                                         XXXXX

And so on. This entry will be passed at the end of EACH month until maturity.

In case the bank does not receive the possession of the goods by month-end and therefore could not sell the goods in the market, the bank will not accrue income for the month and the above-mentioned entry would NOT be passed. Apart from this, entries numbers 2, 3, and 4 will also not be passed since the bank has not yet possessed the goods. If the bank receives the goods in the next month then entries from 1 to 3, as mentioned above will be passed. At the month-end accrual for the two months would be booked by the bank as per entry number 4, since the bank did not book income for the preceding month.

On Maturity of Istisna transaction i.e. at the time of receiving of final payment, following entry would be passed:

  • Dr. Party Bank A/c                          XXXXX
  • Cr Istisna Financing                        XXXXX
  • Cr Istisna Profit Receivable             XXXXX

The Accounting entries are based upon the practice of Meezan Bank Limited (MBL) and may vary from bank to bank.

Risk Mitigation in Istisna:

Some of the risks that are present in Istisna’ Financing for banks are as follows:

Sno  Risks Details Mitigants
1 Delivery risks Delay in delivery of goods from the manufacturer Istisna price can be reduced on daily basis to penalize the manufacturer.
2 Non-performance The manufacturer may not be able to manufacture the goods during the assigned time and refuses to carry on the responsibility further. Bank can terminate the Istisna agreement and demand the price back from the manufacturer. Alternatively, the price may be paid by the bank in installments after being satisfied with the performance.
3 Quality Risk The manufacturer delivers defected/inferior goods Bank has the right to reject the goods and demand the price back.
4 Price Risk The market price of the subject matter decreases after the bank enters into the Istisna agreement. Parallel Istisna or promise to purchase from a
third party will mitigate the risk.
5 Storage risk The goods once delivered by the manufacturer will be a bank’s risk before the same is sold to the ultimate purchaser. This may be covered through Takaful of the goods and by minimizing the time duration between acceptance of delivery under Istisna and delivery to the ultimate purchaser.
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