Loss, according to Islamic scholars, is erosion of capital and will be borne by the partners on the basis of their respective capital. This principle of distribution of loss on capital ratio has been recognised in the contemporary accountancy practice and referred to as Garner vs. Murray rule. However, that rule relates to insolvency stage of a partnership business whereas the stand of the Islamic scholars is that it should be applied as a matter of routine.
This is a basic requirement in financing under Islamic perspective that all the parties should mutually agree on the quantum of their capitals and the method for accounting of capital. The prospective partners should agree at least on following two issues:
1. Accounting or otherwise of goodwill of the older partner, where a new one is joining at a later stage.
2. Basis of accounting of capital; either on Fixed Capital or Fluctuating Capital systems. This is particularly relevant for sharing of interim losses.
For short term financing arrangements, either in the beginning of any venture or project financing in later periods, it is advisable to opt for Fixed Capital system considering the initial share in finance as the basis on which losses would be borne.
SHORT TERM FINANCING
The object of this paper is to initiate a discussion on corporate finance. One such aspect for discussion is the case of financing in following two situations.
1. Short term partnership in the initial period of business
2. Project financing in the interim period
As against the practice of business partnership for long periods, the practice of short term financial arrangement in the initial period of a business has very good potential. This has resulted in enormous growth in Silicon Valley in the USA. This type of finance is provided by venture capitalists or angel financers on equity basis. Venture capitalists arrange their own fund on mutual fund basis and invest in prospective businesses. Angel financers, on the other hand, are individuals with surplus fund who enter into such arrangements. Such finance providers remain partners for few years and then take back their capital and accumulated profits and let the business continue as usual. So the issue that has to be resolved by Islamic scholars is that of ascertainment of profit or loss in the period of association and the accounting at the close of the venture without closing the business.
The margin required to be invested by the entrepreneur is his share of capital and the investment by the venture/angel capitalists is their share. Thus if the funding is done on a margin of 15% the capital ratio between entrepreneur and financer is 15:85.
An ongoing business may need short term financial arrangement to finance a particular project. This is the case of a business continuing before this arrangement and which shall continue in future after the expiry of this. A method for profit sharing by short term partners is proposed with the help of following computation.
A TYPICAL PROFIT AND LOSS ACCOUNT
Table-1
Particulars Rs. Rs.
Sales 200,000
Add: Closing Stock 20,000
220,000
Less: Opening Stock 30,000
Purchase 60,000
Wages 15,000
Other Direct manufacturing expenses 10,000 (115,000)
Gross Profit (GP) 105,000
Less: Salaries 15,000
Other Overheads 25,000 (40,000)
Profit before tax and depreciation (PBDT) 65,000
Less: Depreciation (12,000)
Profit before tax (PBT) 53,000
Less: Tax (13,000)
Net Profit (NP) 40,000
The parties may agree to share profitability on the basis of Gross Profit (GP), or on Profit Before Depreciation and Tax (PBDT) or at Profit Before Tax (PBT) or at Net Profit (NP).
This system is advantageous to the entrepreneur because he need not share his total business accounting and, may be, trade secrets with the project financer. Sharing information up to the stage agreed for profit sharing shall suffice. However, this system has the disadvantage that the entrepreneur may actually suffer loss after full accounting although he might have provided share of ‘profit’ for the project financer earlier!
The advantage described in the above paragraph may be ensured while avoiding the disadvantage by adopting marginal costing method; bifurcating expenses into fixed and variable. In that case profitability may be shared at ‘contribution’ which is computed by deducting variable expenses from gross income/sales. This system is justified where fixed expenses are recovered by the business as usual. So the marginal increase in profit on account of the new project may be shared between the entrepreneur and the project financer.
Computations in the following Table have been done in order to elaborate the proposal as above.
A TYPICAL PROFIT AND LOSS ACCOUNT PREPARED ON MARGINAL COSTING METHOD
Table-2
Particulars Rs.
Gross Income 900,000
less: Variable expenses (550,000)
Contribution 350,000
Less: Fixed expenses (100,000)
Profit before tax and depreciation 250,000
Depreciation (30,000)
Profit before tax 220,000
Tax (2,100)
Net Profit 217,900
The data as above has been used from the final account of a software professional. He has negotiated for a software development job which will yield an additional income of Rs.500,000 and the additional expenses estimated by him is Rs. 225,000 as the cost of engaging/outsourcing professional for completing the job.
He envisages no further fixed expenses because the existing business will take care of his expenses like office rent and other office establishment expenses. He needs fund for executing this job and a friend is ready to finance up to Rs.400,000. So based on this the real time data the entrepreneur wants to know the basis of sharing profit with his friend without sharing his existing business details.
Contribution from this project is Rs.500,000 minus Rs.225,000 = Rs.275,000
However, he will require one computer with proper systems to execute the job which will cost him further Rs.100,000. As this new asset will remain with him even after the project period it will not be justified to charge this cost in total on the project. He can at best charge depreciation on this asset for the period of the project. Considering the project period to be 9 months and rate of depreciation on computer and its software as 60% the share of chargeable depreciation on the project shall be 60% of Rs. 100,000*9/12 = Rs. 45,000.
Thus profit may finally be shared on the differential gain as under:
= Contribution minus depreciation
= Rs.275,000 – Rs.45,000
= Rs.230,000
This gain can be shared by them on any agreed ratio. However, ratio for sharing loss between the entrepreneur and the financer shall be 1:4.
The final account of the entrepreneur after executing this arrangement may be as under:
Table-3
Particulars Rs.
Gross Income 1400,000
less: Variable expenses (775,000)
Contribution 625,000
Less: Fixed expenses (100,000)
Profit before tax and depreciation 525,000
Depreciation (90,000)
Profit before tax 435,000
Tax (24,200)
Net Profit 410,800
Thus we may conclude that issues relating to corporate finance in Islamic perspective may be resolved on case to case basis.
(concluded)
[waquaranwar@yahoo.com]