Tawarruq in concept

Tawarruq (Islamic monetization) is a transaction whereby a person buys an asset/ commodity from a seller on the basis of deferred payment, whether through a musawama or murabaha contract , and sells it to a third party on a cash basis at a given price. In essence, it is a type of sale transaction (ba’i) whereby an entity (or an individual) purchases an asset and sells it to a customer (or to another individual) on credit terms, while the latter’s intention is not to own or control the asset, but it intends rather to sell it after purchase immediately to another party for cash.

The price can be equal to, or higher or lower than the original price. The sole purpose of tawarruq is having access to cash by involving a real, not fictitious, transaction. In this sense, tawarruq differs radically from eina (ba’i al-eina) which constitutes a fictitious transaction meant for paying and receiving riba in the guise of trading profit.

Commercial tawarruq (tawarruq munazzam) is, per se, not a mode of financing or investment, but rather a last resort for cash-tight banks and financial institutions. Such institutions are expected to manage their assets and liabilities using the principal tools of mudaraba, agency to invest, (wakala bil-istithmar), Islamic mutual funds, investment sukuk, etc. However, temporary or short-term liquidity shortage can be covered through tawarruq, provided that no other means are available to the bank and that if it doesn’t resort to tawarruq, its customer base may shrink or its operations may be halted or negatively affected.

Tawarruq transaction legs

Unlike the case of murabaha, a typical tawarruq transaction has three legs- consecutive sales transactions that are conducted in the following sequence:

• Leg 1- a supplier (party A) to a bank (party B): the sale takes place at market price (spot price). Party A receives the market value of the asset.
• Leg 2- the bank (party B) to a customer (party C): the sales takes place on credit (usually on a murabaha basis). Party B earns by obtaining the difference between credit price and spot price. Party C bears the difference of loss (credit price minus spot price).
• Leg 3- the customer (party C) to the eventual customer (party D): the sale takes place at spot. Party D buys the asset at market price. In certain cases, party D is, or assumes the role of, party A, giving rise to ba’i al-eina. Under shari’ah, party D should neither be party A nor a related party (to party D). Collusion (tawatu) as to the roles of each and every party renders the transaction impermissible.

In practice, tawarruq is used by Islamic financial institutions as a preferred instrument or vehicle for liquidity management on both sides (for using excess liquidity and for filling short-term liquidity gaps or shortages).

Accounting for tawarruq

In market practice (or malpractice, so to speak), most market players apply IFRS or other generally accepted accounting principles (GAAP) for tawarruq accounting. At times, certain institutions treat tawarruq and commodity murabaha in a similar manner to murabaha and deferred payment sales, and for that purpose apply the same accounting treatment for murabaha or other deferred payment sales.

For tawarruq transaction to remain shari’ah compliant, it shall always be treated as a genuine trading transaction (true sale), and hence the murabaha requirements provide a basis for such a compliance with the principles and rules of shari’ah. Furthermore, if tawarruq would be considered a finance transaction, then any opportunity cost elements in its pricing would give rise to riba.

Asset side accounting

Tawarruq shall not be used as financing transaction. Different accounting approaches are followed in the market which create certain departures from shari’ah principles and rules. Under one approach, tawarruq is accounted for as financial instrument (i.e., it is carried at amortized cost) on which return accrues using the effective interest rate method (or in the case of certain Islamic financial institutions, using the effective profit or rate of return method).

Another accounting approach considers tawarruq similar to murabaha, and applies murabaha accounting where the gross amount of debt (total dain) is recognized as receivable, while the profit component is deferred and amortized using the effective rate of return method. This approach does not involve any recognition of revenue items (sales revenue and cost of sales).

For asset side accounting to be compliant with shari’ah, the requirements for murabaha transaction accounting, including recognition and amortization of deferred profit, must be properly followed.

Liability side accounting

In market practice (or market malpractice), market players apply the so-called financial instrument approach on the liability side. This approach entails accounting at amortized cost basis). In other words, the tawarruq transaction is dealt with as a debt security or instrument where the liability is recorded at net amount and the accruing return is accounted for using the amortized cost approach. Here also, purchase transactions and cost of sales are not taken into consideration either for treatment or disclosures.

For liability side accounting of tawarruq transactions to be shari’ah compliant, a day-one loss must be recognized at once given that the assets or goods purchased under the first leg are sold immediately thereafter under the second leg. The day-one loss arises from the difference between the purchase price and sale price (where: purchase price > sale price), which is recognized as a trading loss.