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ﻋﻤﻠﻮ ﻴﺎ
ﻗﺪ ﺳ ﻴﻞ ﺟﻔﺎ ﻛﺎﻟﺠﻮ
ﻦ ﻣﺤﺎ ﻳﺐ ﺗﻤﺎﺛ
ﻳﻌﻤﻠﻮ ﻟﻪ ﻣﺎ ﻳﺸﺎ ﻣ
ﻟﺸﻜﻮ
ﺒﺎ
ﻦ ﻋ
ﻴﻞ ﻣ
ﺷﻜﺮ ﻗﻠ
They made for him whatever he wished of sanctuaries, and statues, and basins as
[large as] great watering - troughs, and cauldrons firmly anchored. [And We said:]
“Labour, O David’s people, in gratitude [towards Me] and [remember that] few are
the truly grateful [even] among My servants!”
ﺛﺒﺘﺖ ﻣﺸﺮوﻋ ﺔ اﻻﺳﺘﺼﻨﺎع ﺑﺎﺳﺘﺼﻨﺎع اﻟﻨﺒﻲ )ص( اﻟﺨﺎﺗﻢ واﻟﻤﻨﺒﺮ وﺑﺎﻻﺳﺘﺤﺴﺎن واﻟﻘﻮاﻋﺪ اﻟﻌﺎﻣﺔ ﻓﻲ
.اﻟﻌﻘﻮد واﻟﺘﺼﺮﻓﺎت واﻟﻤﻘﺎﺻﺪ اﻟﺸﺮﻋ ﺔ
The legitimacy of Istisna’a is based on the request of the Prophet, peace be upon him,
that a pulpit (a platform) for preaching and a finger ring be manufactured for him. An
Istisna’a contract is also permissible on the basis of the principle of istihsan (public
interest or good), the general principles of contracts and transactions and the objectives
of Shari’a.
Chapter 12
CHAPTER LEARNING OBJECTIVES:
At the end of this chapter you will, insha Allah you will be able to:
i. Explain the meaning of Istisna’a’ and parallel istisna’a’ and how these
contracts are used by Islamic banks to finance customers
ii. List the principles of istisna’a’ and as well as explain the shari’a rules.
iii. Journalise accounting entries for istisna’a’ and parallel istisna’a’.
iv. Prepare the balance sheet and income statement extracts for
istisna’a’ and parallel istisna’a’ transactions
v. Apply shari’a and accounting principles as per FAS 10 to solve
accounting problems for complex events.
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12. 1 Introduction
Besides salam, istisna’a’ is the other contract where a sale can be made without the
subject matter of the contract being in existence at the time of contracting. Whereas salam
is a contract for delivery of a commodity, which might be grown or bought by the muslaim
ileihi to be delivered to the muslam at a future date, istisna’a’ is a contract to manufacture
the goods to specification and deliver the manufactured goods to the buyer at a future
agreed date, the payment being in advance or deferred or in installments.
Islamic banks have used this contract to finance infrastructure projects such as power
plants, planes, highways etc. How do the Islamic banks do this when they are not
construction contractors, airplane manufacturers or highway experts? These they do by
means of a parallel istisna’a contracts where the manufacturer is commissioned to
manufacture and deliver to the Islamic bank (actually their customer – imagine a plane is
parked next to a Islamic bank building!) which in turn is delivered to the bank’s customer.
From an accounting point of view, istisna’a is complex to account for as the costs of
construction has to be accumulated and progress payments billed and tracked as in
construction contract accounting IAS 11. Further the most important event is the
recognition of profits using the percentage of completion method which is now the
standard practice under IAS 11, when the outcome of a contract can be estimated
reliably. FAS 10, however, allows the completed contracts method, where no profits are
recognized but costs are accumulated to the amount they are expected to be recoverable.
Following the prudence concept, if any time during the istisna’a’ contract, there is a
expected loss or the cash equivalent value of the work in progress is less then the contract
amount receivable, then the work in progress will have to be written down to the cash
equivalent value.
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Definitions
Istisna’a
It is a sale contract between al-mustasni’ (the ultimate purchaser) and al-sani’,
(seller) whereby al-sani’ - based on an order from the al-mustasni’- undertakes
to have manufactured or otherwise acquire al-masnoo’ (subject matter of the
contract) according to specification and sell it to al-mustasni’ for an agreed
upon price and method of settlement whether that be at time of contracting, by
instalments or deferred to a specific future time. It is a condition of the Istisna’a
contract that al-sani’ should provide either the raw material or the labour.
Parallel Istisna’a
if al-mustasni’a (the ultimate purchaser) does not stipulate in the contract that
al-sani’ (seller) should manufacture the al-masnoo’ by himself, then al-
sani’ may enter into a second Istisna’a contract in order to fulfil his
contractual obligations Contract losses
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ISLAMIC
BANK 4
Manufacturer 3 (al sani in the Bank’s
istisna’ contract customer
Al Sani in the and al mustasni in Al mustasni
parallel istisna The parallel in the istisna’
istisna contract) 1 contract
2
3 The manufacturer manufactures and bills the bank periodically and delivers
the goods to the bank (actually the customer) at the end of the contract.
1 Legitimacy
Istisna’a is considered a special case of salam. It grew out out of the Salam
contract and has similar provisions and rules. It arose out of jurisprudential
engineering of the Hanafi school which approved its validity based on
istihsan (equity). Istisna’a is valid also based on ibaha (permissibility if not
contrary to scriptural text). Hence, we can say Istisna’a is valid from the
consensus (ijma) of islamic scholars.
Al mustasni has a right to get collateral for the amount he has paid.
He also the right to get collateral for delivery in accordance wth specification
and on time
Further, al sani has the right to secure collateral to guarantee that the price is
payable on time.
Al mustasni can insert a penalty clause in the contract against unfullfillment
of obligations .
8 Termination of contract
The contract of Istisna’a’a may be terminated under the following
conditions:
(a) Normal fulfillment of obligations by both parties.
(b) Mutual consent of both parties.
(c) Judicial rescission of the contract. This is if a reasonable cause
arises to prevent the execution of the contract or its completion,
and each party may sue for its rescission(1).
9 Options on Non-compliance
1
() See Recent Civil Islamic Legislations; Abdallah, A.A., op. cit, pp. 61-62.
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9 Parallel Istisna’a
If al-mustasni’a (the ultimate purchaser) did not stipulate in the
contract that al-sani’ (seller) should manufacture the al-masnoo’ by
himself, then al-sani’ may enter into a second Istisna’a’a contract in
order to fulfil his contractual obligations in the first contract. This new
contract is known as parallel Istisna’a’a, which is in essence a
subcontract whereby the obligation of al-sani’ in the first contract are
carried out. Nevertheless,
(a) The Islamic bank as al-sani’ in the first contract will remain
solely responsible for the execution of his obligations as if the
parallel contract is non-existent. Hence, al-sani’ in the first
contract would remain liable for any default, negligence or
breach of contract ensuing from the parallel contract.
(b) Al-sani’ in the parallel Istisna’a’a is accountable to al-mustasni’
(Islamic bank) in the way and manner by which he performs his
obligations. He has no direct legal relationship with al-mustasni’
in the first contract. The second Istisna’a’a is a parallel contract,
but not a contingent transaction on the first contract. Legally
speaking they are different contracts with respect to rights and
obligations.
2
() Abdallah, A.A., op. cit., pp. 62-66.
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12.4.1 Accounting treatment in the books of the Islamic bank as the seller (al sani’).
DR CR
ISTISNA’ ISTISNA
Progress payment billings ACCOUNTS BILLINGS
to al mustasni RECEIVABLE ACCOUNT
ISTISNA
Receipts on Account CASH ACCOUNTS
RECEIVABLE
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As can be seen from the above illustration, the following are the main transactions and
their treatment.
(i) all direct and indirect istisna’a costs are debited to a istisna’a works in progress
account. Direct costs are those such as material and labour incurred the manufacture of al
masnoo’. Indirect costs relating to the contract which can be allocated on an objective
basis are also debited to this account. However general administration, selling, research
and development costs should not be included under istisna’a contract costs.
(ii) all pre-operating contract expenses are debited to a deferred costs before the
execution of the contract and upon execution of the contract transferred to the Istisna’a
work in progress account.
(iii) Amounts billed to al-mustasni’ will be debited to istisna’a accounts receivable account
and credited to istisna billings account.
(iv)if the percentage of completion method is used , then a part of the contract price
commensurate with the work completed is recognized in an istisna revenue account using
the formula:
and the portion of the profit recognized is debited to istisna’a work in progress account
using the formula below:
This method is used when both the percentage of completion and the expected cost to
complete the contract cannot be reasonably estimated, no contract revenue or profit is
recognized until the completion of the contract. In this case, the accumulated costs will be
carried forward in the istisna’a work in progress account.
Unlike a salam contract, where the payment must be made in advance, in an istisna’a
contract, the price is can be paid in advance, in installments or deferred. The normal
practice is the payment is made in installments. For Islamic bank customers, the financing
motive means that the installments period will often run after the contract is completed and
the al masnoo delivered. In this case, all the profits cannot be recognized in the accounts
before the time the al-masnoo’ is delivered. A portion of the profits pertaining to the unpaid
installments should be deferred. The deferred profit must be deducted from the Istisna’a
Accounts Receivable in the Balance Sheet.
The standard requires that the preferred method of allocation of deferred profits is by
proportionate allocation of deferred profit over the future financial period of credit, whereby
each financial period will carry its portion of profit, whether or not, cash is received. This
statement is not clear, it could mean the bank can allocate the deferred profit by equally
over the remaining credit period (similar to straight line depreciation) or in proportion to the
amounts receivable per payment schedule. The latter appears as a better interpretation.
However, if the bank’s SSB or regulatory authorities approve, then the deferred profit is
allocated in proportion to the installments received.
There seem to be an error in the English version of the standard FAS10,, para 11
(2/3/2). The English version defines the deferred profit as the difference between the
contract price and the installments paid during the contract term. This is actually the
accounts receivable. Netting this amount against the Istisna’a Accounts Receivable will
make it nil. In the Arabic version of the standard, no such definition is given. Since the
Arabic version of the standards are to be followed in case of conflict, this definition is
ignored in this book.
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The Islamic Bank may (not must) waive a part of its profit in case of advance payment and
this rebate will be deducted from Istisna’a accounts receivable and deferred profits
The same treatment is effected if the al mustasni paid the whole amount and the bank
refund the rebate to the customer.
If the al mustasni requests for a change in the specifications in the al masnoo or additional
work, and the al sani agrees to this, the value and cost of the change orders must be
added to the istina’a costs and revenues respectively. Additional claims made by al sani
in excess of the contract price for delays, errors in specifications and designs or other
causes of unanticipated costs caused by al mustasni’, an additional amount of revenue
equal to the additional costs should be recognized provided, there is a legal basis
supported by verifiable evidence (see definition below for further conditions). If the
conditions for recognition of additional claims are not satisfied, then an estimated value of
these claims should be disclosed in the notes to the financial statements.
Definitions
Change orders
Approved modifications in specifications, quantities, design, or other attributes defined in
the original Istisna’a contract the implementation of which affects contract costs.
Additional claims
Amounts in excess of the agreed Istisna’a contract price which are claimed by al-sani’ for
delays, errors in specifications and designs or other causes of unanticipated costs caused
by al-mustasni’. Recognition of these claims by al-sani’ requires the satisfaction of the
following conditions:
(a) The existence of a legal basis for the additional claim supported by objective and
verifiable evidence.
(b) Claims must be due to circumstances that were unforeseeable at the contract date
and are not the result of the deficiencies, fault or negligence of al-sani’.
(c) Costs associated with the additional claim are identifiable and reliably estimable.
These costs should be accounted for on an accrual basis. These costs should be
estimated and matched with istisna’a revenue. Actual maintenance and warranty
expenses should be charged against an Allowance for Maintenance and Warranty
Account, when carried out by the Islamic bank. In case of a parallel istisna’a, the
maintenance and warranty costs should be charged as incurred to expense accounts.
receivable receivable)
12.4.2 Accounting treatment in the books of the Islamic bank as the buyer(al
mustasni) – parallel istisna’a contract.
(i) Only the completed contracts method is recognized in the case of parallel istisna’a
because both the revenues and costs (being billed to the bank by al sani) are known with
reasonable certainty.
(ii) The costs billed by the contractor to the Islamic bank are accumulated in a Istisna’a
costs account (as opposed to an Istisna’a work in progress account in istisna’a contract).
The credit entry is to an Istisna’a accounts payable. The recognized portion of profit
for a financial period is added to the Istisna’a cost account.
When the contractor delivers al masnoo to the bank, in conformity to specifications and
schedules., the bank should record the asset at historical cost (i.e. book value) of the
Istisna’a cost account. The balance of the Istisna’a costs should be transferred to an asset
account reflects the nature of the asset. E.g. fixed asset or investment in ijarah assets or
istisna assets.
IN case delay is due to negligence or fault of al sani and the Islamic bank is entitled to
compensation for damages resulting from the delay, this should be first deducted from
performance bonds. If insufficient, the deficit is an Istisna’a accounts receivable from al
sani’ subject to allowance for doubtful debts.
If the bank declines to accept it, and it does not recover all its payents to the al sani’, the
un-recovered balance becomes a receivable subject to allowance for doubtful debts.
If the bank accepts al masnoo’ it will be measured at the lower of the cash equivalent
value or historical cost. Any resulting uncompensated loss should be written off for the
current accounting period.
The masnoo will be carried at lower of cash equivalent value or historical cost. Any
resulting loss will be written off in the accounting year in which it is realized.
Summary of journal entries in the books of the bank as buyer (al mustasni)
Balance Sheet
Income Statement
Istisna’a Revenue XX
Less costs of istisn’a Revenue (XX)
Less Deferred profits in future installments (XX)
Less losses on istisna/reduction to cev (XX)
Add reversal of deferred profit XX
XYZ Islamic Bank entered into a two-year Istisna’ contract to construct a diesel power
generator for a total price of $600,000 commencing ! January 2002. The
following costs were estimated at the time of concluding the contract.
Billings were made in tear 2002 for $225,000 and the remaining balance was billed
at the end of year 2003.
Following is the payment schedule that was agreed with the client of XYZ Islamic
Bank :
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The XYZ Islamic Bank incurred general and administration expenses totalling $5,000
during 2002.
Substantial increase in material cost occurred in 2003 due to the liquidation of a major
supplier for the said material. Accordingly, the bank revised its cost estimate
for material to be $60,000 higher than previous planned.
Required :
Prepare all necessary journal entries for the years 2002 to 2006 to record the above
transactions in the books of XYZ Islamic Bank .
Prepare the statement of financial position and income statement of the XYZ Islamic
Bank for the year 2002 and 2003 to present the transactions relating to the
contract.
Dr.Cash 60,000
Cr. Istisna accounts receivable 60,000
Dr.Cash 60,000
Cr. Istisna accounts receivable 60,000
Dr.Cash 12,000
Cr. Istisna accounts receivable 12,000
Dr.Cash 180,000
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Dr.Cash 180,000
Cr. Istisna accounts receivable 180,000
b.
XYZ Islamic Bank
Statement of financial position as at 2002
2002
2003
2002
2003
a) Topkapi Hillview estate is the seller (al-sani’) and Zain Islamic bank is the agent of the
purchaser (al-mustasni’).
b) The 25 semi detached villas is the asset (al-masnoo’) and Aksaray Construction Company is
the seller (al-sani’).
c) Topkapi Hillview estate is the purchaser (al-mustasni’) and Zain Islamic bank is the agent of
the seller (al-sani’).
d) Zain Islamic bank is the seller (al-sani’) and the Aksaray Construction Company is the
purchaser (al-mustasni’).
2. An Islamic Bank has agreed to construct a manufacturing facility for its customer
through an Istisna’ contract.
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The total contract price is US$ 1,700,000 while the contract cost is estimated at
US$ 800,000. Construction is estimated to be completed in 2 years.
By end of Year 1, the cumulative costs incurred were US$ 300,000 including pre-
contract costs of US$ 45,000.
Assuming all these costs were paid off by cash, which of the following journal
entries are correct for Year 1:
a)
Dr Cr
Istisna’ Work in progress 345,000
Cash 300,000
Deferred cost 45,000
b)
Dr Cr
Istisna’ Work in progress 300,000
Cash 255,000
Deferred cost 45,000
c)
Dr Cr
Istisna’ accounts receivable 300,000
Istisna’ work in progress 300,000
d)
Dr Cr
Cash 345,000
Istisna’ Work in progress 300,000
Deferred cost 45,000
a)
Dr Cr
Istisna’ Work in progress 300,000
Cash 300,000
b)
Dr Cr
Istisna’ Work in progress 500,000
Cash 300,000
Istisna’ billings 200,000
c)
Dr Cr
Istisna’ accounts receivable 300,000
Istisna’ work in progress 300,000
d)
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Dr Cr
Cash 300,000
Istisna’ Work in progress 300,000
5) Which of the following statements regarding the price of an Istisna’ asset is false?
a) The price should be known to the extent of removing lack of knowledge.
b) The price cannot be increased or decreased on account of the normal increase or decrease in
commodity prices or cost of labour.
c) The price may be changed by the mutual consent of the contracting parties due to unforeseen
contingencies such as modifications required to the construction.
d) All of the above is false.
Question 12-1
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Question 12-2
i. RHB Islamic Bank Islamic entered into a 4 year Istisna’a contract with
the Malaysian government to build a bridge over the PutraJaya river at
$100 million and payable by the Malaysian government as follows:
The istisna’a contract stipulated any increase in costs will be borne by the
bank and will not be passed on to the government. However, the
government would not charge any penalty for late completion of up to a
year.
At the same time, RHB Islamic Bank entered into a parallel Istisna’a contract
worth $80 million with Islamic Engineers Malaysia to build, test and hand
over the bridge over a two year period. Islamic Engineers did not agree to
bear any additional cost over run. The bank agreed to pay Islamic Engineers
a 10% initial payment on the signing of the contract. Subsequent payments
by the bank would be in 30 days after each progress billing was made to the
bank.
In the first year, Islamic engineers billed $32 million to the bank. In the
second year however, costs escalated and Islamic Engineers informed the
bank that it would cost an additional $ 25 million to complete the bridge
and required an extension of 6 months. They billed the bank another
$50million during the second year.
In the third year, Islamic engineers completed the bridge. However, the
actual costs had only gone up by $20 million and Islamic Engineers agreed
to pay a penalty of $ 5 million according to the istisna’a contract for late
completion. The SSB of RHB Islamic had established that any late payments
by sub contractors was not considered as riba and to be taken as revenue of
the bank. Islamic Engineers billed the bank the remaining amount during
the third year and was paid accordingly in the same year.
Required:
Journal entries in the books of RHB Islamic Bank for the above transactions
from year 1 to 4 if profits are recognized on an (a) accrual basis and (b) end
of contract basis.
( IIUM MBA, 2005/2006, Q5b )
Question 12-4
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A.
Dubai Investment House (DIH) , an Islamic bank signed an Istisna’a contract
with Malaysian Nuclear Agency (MNA) on 1 Jan 2006 to build and deliver
a nuclear reactor for $300 Million on 31st December 2007. MNA would pay
10% of the contract price on the signing of the contract to DIH and DIH
would bill MNA for the remaining amount of the contract as per the
following schedule:
31 /12/2006 20%
31/12/2007 30%
31/12/2008 20%
31/12/2009 20%
MNA would not accept any cost escalation but would not charge DIH any
penalty if the reactor was delayed NOT beyond 1 year from the schedule
delivery date of 31st December 2007. DIH billed MNA per the above
schedule and was paid on 31st January in the year following the billing date.
Nucleon agreed to deliver the reactor on 31st December 2007 failing which
DIH would charge Nucleon a penalty of 10% per annum of the contract
price on a prorata basis based on time. Nucleon refused to bear any cost
escalation. It would simply pass on the costs to DIH.
The following billings were made by Nucleon to DIH and DIH paid
Nucleon in 60 days after the billing date
In February 2007, Nucleon informed DIH that the cost of the reactor had
escalated and it would now cost $320 Million and delivery would be
delayed until 30 Jun 2008. It billed DIH another $200M on 1st November
2007, which DIH paid in 31st January 2008. In Jun 2008, Nucleon delivered
the completed reactor. Nucleon billed the remaining costs of the contract
less the penalty it had to pay on 30 Jun 2008 and was paid by DIH 60 days
thereafter.
Required:
(i) Provide the necessary T accounts (NOT journal entries) in the books of
DIH for the contract from 1st January 2006 until the final payment was
settled by MNA assuming DIH uses the percentage of completion method
to calculate profits.
(ii) An extract of the Income statements and Balance Sheet for the necessary
years.
(IIUM B.Acc, semester 1, 2006/2007, Q1a)
B.
Question 12-5
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AmBank Islamic entered into a 4 year Istisna’a contract with the Malaysian
government to build a bridge over the Kelang river at $100 million
and payable by the Malaysian government as follows:
The istisna’a contract stipulated any increase in costs will be borne by the
bank and will not be passed on to the government. However, the
government would not charge any penalty for late completion of up to a
year.
At the same time, AmBank Islamic entered into a parallel Istisna’a contract
worth $80 million with United Engineers Malaysia to build, test and hand
over the bridge over a two year period. United Engineers did not agree to
bear any additional cost over run. The bank agreed to pay United Engineers
a 10% initial payment on the signing of the contract. Subsequent payments
by the bank would be in 30 days after each progress billing was made to the
bank.
In the first year, United engineers billed $32 million to the bank. In the
second year however, costs escalated and United Engineers informed the
bank that it would cost an additional $ 25 million to complete the bridge
and required an extension of 6 months. They billed the bank another
$50million during the second year.
In the third year, united engineers completed the bridge. However, the
actual costs had only gone up by $20 million and United Engineers agreed
to pay a penalty of $ 5 million according to the istisna’a contract for late
completion. The SSB of AmBank Islamic had established that any late
payments by sub contractors was not considered as riba and to be taken as
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revenue of the bank. UEM billed the bank the remaining amount during the
third year and was paid accordingly in the same year.
Required:
Journal entries in the books of AmBank Islamic for the above transactions
from year 1 to 4 if profits are recognized on an (i) accrual basis and (ii) end
of contract basis.
Question 12-6
In the year 2006, the Islamic Development Bank of Brunei (IDBB) entered
into an Istisna’a’a contract with Malaysian government to build and deliver
a highway project at $15 million in three years time, to be delivered at the
end of year 2008. The bank billed Malaysian government as follows:
The government paid the bank one month after the billing date.
The Istisna’a’a contract clearly indicated that any increase in costs will be
borne by the bank and will not be paid by the government. However, the
government agreed not to charge any penalty if the bank is able to deliver
within 6 months after the due delivery date.
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The bank agreed to pay Plus Berhad a 10% initial payment on the signing of
the contract. Subsequent payments by the bank would be two months after
each billing was made to the bank. The payments made by Plus Berhad
during the first two years are as follows:
In year 2008, the total costs were anticipated to increase to $16 million and
Plus Berhad informed the bank that they required an extension of six
months. They billed the bank $4 million during the year 2008.
In July 2009, Plus Berhad completed the highway. However, the actual costs
has only increased to $14 million. Plus Berhad billed the bank the remaining
amount during year 2009 and was paid accordingly in the same year.
Required:
b. An extract of the income statement and Balance Sheet for the necessary
years.
Question 12-7
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1. Copy the table below to your answer book and complete the table
showing the similarities and differences between salam and istisna’a
contracts.
Parallel
Contract
The contract called for billings and payments to be made by the end of
the each financial year which coincided with the contract. At the same
time Bank Salim entered into a parallel istisna’a agreement with
Malaysian Airperahu Industries to buy the two aircraft for $80 million
deliverable in the two years.