'Effective Profit Rate Method’ and Revenue Recognition of Islamic Banks: Risk Sharing or Risk Transfer?

Abstract

This paper examines the impact of using the ‘Effective Profit Rate Method’ (EPRM) in estimating revenue from the financing activities of Islamic Banks (IBs). Data for the study were sourced from audited financial statements, Islamic finance contracts (i.e. Al Ijarah Thumma Al Bai @ Islamic leasing) and interviews with three Islamic finance experts. It was found that EPRM is widely used by Islamic banks in Malaysia and the sale-based contract was found to be the single major (>75%) financing mode. Simulation of the repayment schedule for the Al-Ijarah Thumma Al-Bai (AITAB) financing arrangement indicates that IBs collected a large proportion of the revenues in the early years of the financing period and payments of principal by customers are proportionately low at the beginning of the financing period. The findings were subsequently benchmarked using the ‘Straight Line Method’ (SLM) and an equal distribution of revenues and payment of principal was observed throughout the financing period. The above results raised a concern regarding the nature of the customer-financier relationship. This concern stems from the fact that Islamic finance is built on the concept of ‘Risk Sharing’ instead of ‘Risk Transfer’. When a customer terminates their financing contract in the early years of the financing period, the IB has collected a relatively bigger portion of revenues, while the customer has made lower payments of principal. This outcome raised our concern as to whether EPRM is a ‘Risk Sharing’ or a ‘Risk Transfer’ mechanism, and whether the bank exploited their superior position by imposing EPRM that gives them advantages to shift their financing risk. Also, the customer is placed at a disadvantage, as this technique will directly or indirectly protect the IB from early termination of financing contracts. Islamic finance experts provide mixed views on the above observation. The interviewees acknowledged the importance of this issue to the industry and to the public. Regulators, bankers and other stakeholders should look critically into this matter and provide clear guidance to the market players.